The Myths of Market Prices and Efficiency

In my two previous posts I described a pair of prevalent myths regarding how economists think about the environment: “the myth of the universal market” ­– the notion that economists believe that the market solves all problems; and “the myth of simple market solutions” — the notion that economists always recommend simple market solutions for social problems. In response to those two myths, I noted that in the environmental domain, perfectly functioning markets are the exception, not the rule; and that no particular form of government intervention is appropriate for all environmental problems.

A third myth is that when non-market solutions are considered, economists use only market prices to evaluate them. No matter what policy instrument is chosen, the environmental goal must be identified. Should vehicle emissions be reduced by 10, 20, or 50 percent? Economists frequently try to identify the most efficient degree of control — that which provides the greatest net benefits. This means that both benefits and costs need to be evaluated. True enough, economists typically favor using market prices whenever possible to carry out such evaluations, because these prices reveal how people actually value scarce amenities and resources. Economists are wary of asking people how much they value something, because respondents may not provide honest assessments of their own valuations. Instead, economists prefer to “watch what they do, not what they say,” as when individuals reveal their preferences by paying more for a house in a neighborhood with cleaner air, all else equal.

But economists are not concerned only with the financial value of things. Far from it. The financial flows that make up the gross national product represent only a fraction of all economic flows. The scope of economics encompasses the allocation and use of all scarce resources. For example, the economic value of the human-health damages of environmental pollution is greater than the sum of health-care costs and lost wages (or lost productivity), as it includes what lawyers call “pain and suffering.” Economists might use a market price indirectly to measure revealed rather than stated preferences, but the goal is to measure the total value of the loss that individuals incur.

For another example, the economic value of some parcel of the Amazon rain forest is not limited to its financial value as a repository of future pharmaceutical products or as a location for ecotourism. Such “use value” may only be a small part of the properly defined economic valuation. For decades, economists have recognized the importance of “non-use value” of environmental amenities such as wilderness areas or endangered species. The public nature of these goods makes it particularly difficult to quantify the values empirically, as we cannot use market prices. Benefit-cost analysis of environmental policies, almost by definition, cannot rely exclusively on market prices.

Economists try to convert all of these disparate values into monetary terms because a common unit of measure is needed in order to add them up. How else can we combine the benefits of ten extra miles of visibility plus some amount of reduced morbidity, and then compare these total benefits with the total cost of installing scrubbers to clean stack gases at coal-fired power plants? Money, after all, is simply a medium of exchange, a convenient way to compare disparate goods and services. The dollar in a benefit-cost analysis is nothing more than a yardstick for measurement and comparison.

A fourth and final myth is that economic analyses are concerned only with efficiency rather than distribution. Many economists do give more attention to aggregate social welfare than to the distribution of the benefits and costs of policies among members of society. The reason is that an improvement in economic efficiency can be determined by a simple and unambiguous criterion C an increase in total net benefits. What constitutes an improvement in distributional equity, on the other hand, is inevitably the subject of much dispute. Nevertheless, many economists do analyze distributional issues thoroughly. Although benefit-cost analyses often emphasize the overall relation between benefits and costs, many analyses also identify important distributional consequences. Indeed, within the realm of global climate change policy, much of the economic analysis is dedicated to assessing the distributional implications of alternative policy measures.

So where does this leave us? First, economists do not believe that the market solves all problems. Indeed, many economists make a living out of analyzing Amarket failures@ such as environmental pollution in which laissez faire policy leads not to social efficiency, but to inefficiency. Second, when economists identify market problems, their tendency is to consider the feasibility of market solutions because of their potential cost-effectiveness, but market-based approaches to environmental protection are no panacea. Third, when market or non-market solutions to environmental problems are assessed, economists do not limit their analysis to financial considerations, but use monetary equivalents in benefit-cost calculations in the absence of a more convenient unit. Fourth and finally, although the efficiency criterion is by definition aggregate in nature, economic analysis can reveal much about the distribution of the benefits and the costs of environmental policies.

Having identified and sought to dispel four prevalent myths about how economists think about the natural environment, I want to acknowledge that my profession bears some responsibility for the existence of such misunderstandings about economics. Like our colleagues in the other social and natural sciences, academic economists focus their greatest energies on communicating to their peers within their own discipline. Greater effort can certainly be given by economists to improving communication across disciplinary boundaries. And that is one of my key goals in this blog in the weeks and months ahead.

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7 Responses to The Myths of Market Prices and Efficiency

  1. Michael Kelly says:

    Use value
    Option Value
    Existence Value

    Generational equity

    Yes, it’s been over two decades since those seminars. Glad to see that they still apply. It makes us economists more … human.

  2. Darren says:

    This is a great piece. I often have this discussion with my non-economist friends… I will save this essay and give it to them to illustrate what I am trying to say.

    Economics does need to be more serious about engaging with non-economists…. we could do a great deal of good this way.

  3. Bransby says:

    I don’t dispute anything you’ve said here in what’s essentially a defence of Economics as a discipline, but it doesn’t say much to explain why, after 30 years of economic theory dominating the way western society is governed, both our economy and our environment are so utterly buggered.

  4. Bransby, thanks for your comment. I would respectfully disagree with your implicit premise that “economic theory” — or economic thinking and/or economists, for that matter — have dominated the way we address the environment in the western world (or elsewhere). On the contrary, since 1970 — which we may take as the approximate beginning of modern environmentalism (the first Earth Day) — the dominant approaches to actual public policies in the environmental realm have been decidedly non-economic. That is what my subsequent post (on better water pricing) and many other posts will be about. Clearly, the cause of environmental degradation is economic (environment is a classic externality). Hence, economic thinking and economic approaches can be helpful in reducing such degradation, at least so I would claim. More about that in future posts. Thanks again for your comment,

  5. Tim Ridgers says:

    I agree with Bransby, by narrowly applying economics to all aspects of society we have “buggered-up” many aspects of the environment – greenhouse gases, acid rain, polluted soils, polluted freshwater supplies, and rendered extinct many other species. On top of that we have rendered society more and more unfair and uncaring. The difference between the small number of “haves” and growing numer of “have-nothing” is growing wider and wider. The amount of human suffering created is extraordinary, and yet we are meant to believe we are “better-off” today than 30 years ago. If better off translates only to purchasing power of cheap chinese-made goods, well that is only one very narrow-minded way of measuring the results of civilisation. In many other spiritual domains we are far worse off. Now since we cannot put a price on human suffering, nor can we actually go out and buy a clean earth to start over again, economics has actually failed in my eyes in creating a better world for humankind to live in. So we have to introduce laws to limit the impact of economics. We have being doing this for centuries already, to protect the rights of citizens. Its time we rethought our society in terms other than $$$. Money has become the goal rather than the means to achieve something else. So stop worshipping the dollar god even if tainted in a more green colour, and start working for a better society which goes beyond the rich accumulating huge hordes of money, and everybody else has nothing.

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