182 – Increasing marginal costs of environmental projects

One of the key insights of economics is the idea of increasing marginal costs – as you produce more and more of a good, production usually gets more expensive per unit. This idea usually relates to manufactured goods but is highly relevant to environmental ‘goods’ as well. It has implications for environmental management that often seem to go unrecognised.

Increasing marginal costs is one of the most fundamental ideas in economics. It is the first thing you learn about when studying the economics of production. To force more output out of a given production process, you may have to pay workers more in overtime, or pay more for inputs, or use a more expensive production system, or reduce production of something else that was making you money, so the cost of production goes up.

Evidence for this is everywhere, if you look. For example, consider the fact that, when the price of wheat goes up, farmers around the world quickly increase their production of wheat. This reflects that farmers need a higher wheat price to cover the higher costs of more production. (In the long run, there can sometimes be economies of scale, which go the other way, but that’s another story.)

For some years, a lot of my research has focused on environmental issues related to land use and land management. For issues like biodiversity protection, dryland salinity, soil erosion and nutrient pollution in waterways, the key to improving environmental outcomes is often to change land use or land management.

You could, if you had economic tendencies, think about this as a process of producing or “supplying” environmental goods. The goods are more biodiversity or less-polluted rivers, and the production process consists of changing land use or land management. The more you change, the more environmental goods you produce.

Should one expect increasing marginal costs in this environmental “production” process? Absolutely.

If only very small changes were required, you could cherry pick the cheapest options for change. By picking the cheapest options, you could achieve the greatest environmental improvement that was possible within the environmental budget. As you move to steadily larger targets for change, you aren’t able to be so choosey any more, and are forced into steadily more expensive changes.

For example, if the key response to an environmental issue is conversion of crops to native vegetation, you’d tend to start with those areas where crop production was least profitable (where the “opportunity cost” was lowest). As the required changes increased in extent or intensity, you would have to convert steadily more-profitable crop land, so that, at the margin, the cost of providing greater environmental benefits would increase. The same sort of thing would apply if the changes required were reductions in fertilizer use, or changes in grazing management. In order to maximise environmental outcomes, you’d start with the cheapest options and work up.

Figure 1 is a real example. It is taken from a study we did calculating the cost of achieving different reductions in flows of phosphorus into the Gippsland Lakes in Victoria. Because more ambitious targets for nutrient reductions require us to take up less and less attractive management options, the total cost goes up at an increasing rate. It’s actually quite cheap to reduce nutrients by 10%, but its very expensive to reduce them by 40% – much more than four times as much.

 

Figure 1.

Now, in the world of land and water conservation, an idea that has a lot of currency is that of seeking “landscape-scale” change. The hope is that, by fixing up environmental problems across the whole landscape, you’ll generate benefits that are more than the sum of the parts. It is assumed that by fixing the whole landscape, you can get exceptional aggregate benefits, even if the benefits from fixing up parts of the catchment would be modest.

That may or may not be true in particular cases (see PD183), but either way, it is not just benefits that matter. Especially when considering management of large areas, it is highly likely that making changes across the whole landscape will result in exceptional aggregate costs. For landscape-scale interventions to be better than more targeted interventions, the escalation of benefits as the area treated increases would have to be greater than the escalation of costs. Whether that’s the case would need to be assessed on a case-by-case basis.

Thus, even if one is confident that there will be exceptional aggregate benefits from a landscape-scale response, one shouldn’t just assume that this is the way to go without considering the cost side of the equation. When the environmental budget is limited (and it always is), it may be that the greatest environmental benefits in aggregate can be achieved through a larger number of more modest-scale projects, rather than a small number of huge projects.

David Pannell, The University of Western Australia

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