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Environmental Values and National Economic Accounts

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Recently, suggestions have been made for revising or supplementing national economic accounts so that they reflect welfare changes associated with the degradation of environmental goods and natural resources. This project will provide a comprehensive theoretical examination of potential account revisions. The examination will seek to answer the question: which national account revisions provide information that allows for meaningful comparisons of social welfare? The results of this analysis will provide insight into how to interpret suggested account revisions, emphasize the limitations of these suggestions, and to identify new potential directions for adjusting national economic accounts so that environmental values are accurately reflected.

Metadata

EPA/NSF ID:
R824671-010
Principal Investigators:
Flores, Nicholas E.
Technical Liaison:
Research Organization:
Colorado at Boulder, University of
Funding Agency/Program:
EPA/ORD/Valuation
Grant Year:
1995
Project Period:
October 1, 1995 - June 1, 1997
Cost to Funding Agency:
$43,395
Project Status Reports:
      For the year 1997
      Objective: In recent years there has been considerable discussion over the usefulness of national economic accounts such as Gross National Product, Gross Domestic Product, and Net National Product in gauging economic growth and its contribution to social welfare. The most noted shortcomings of these account measures are their failure to explicitly recognize the contribution of the environment to overall welfare. Numerous suggestions for revising or supplementing the existing set of national economic accounts are found in the literature. Our project goal is to conduct an analysis of the proposed revisions and identify potential strengths and weaknesses.

      The approach we have taken is to develop a basic theoretical model using economic preference and production theory to determine the environment’s contribution to overall economic welfare. The fundamental reason inefficient resource use arises is the lack of markets for most environmental goods. The lack of markets for these goods gives rise to inconsistent economic signals received by producers, whose actions may negatively affect the environment, and consumers, whose welfare is positively affected by environmental quality. Our model has two prominent dynamic features that influence the allocation of resources. First, man-made capital stock, net of depreciation, carries over into future periods and determines future production possibilities. Second, the stock of environmental goods, net of depreciation, also carries over into future periods and provides service flows that contribute to production and consumer welfare. In a departure from existing analyses, we examine the potential public goods nature of environmental goods that arises due to non-use values; technological improvement as well as shifts in preferences that may occur over time; and in some cases, changes to the environment that are irreversible.


      Progress Summary: Our preliminary findings suggest that even when the environment is properly priced in accordance with consumer preferences and producer technologies, some adjusted measures provide little insight into how welfare adjusts with time. Under certain circumstances, adjusted measures may in fact provide the wrong signal, in that the adjusted account may show an increase over time while welfare has instead declined. In cross-country comparisons, environmentally adjusted, net consumption measures will, in many cases, preserve the ordering provided by existing accounts that ignore the environment’s contribution to the economy. With regard to policy implications, our preliminary results suggest that even when environmental values are correctly measured and accounts are adjusted accordingly, the measures should be interpreted with caution. If environmentally adjusted economic accounts are to become an integral part of decision makers’ information sets, the potential shortcomings of these accounts need to be recognized as well.

      Future Activities: The basis of most account adjustment recommendations is a dynamic model that correctly incorporates the environment into economic decisions. In reality, welfare evolves in an inefficient fashion due to the lack of markets for environmental goods. Our next step in the project will be to conduct numerical simulations of a simple dynamic economy as described by the theoretical model. This numerical modeling exercise should yield insight into how well various adjusted account measures reflect changes in welfare over time under the condition of missing markets.
Project Reports:
      Final Executive Summary

      Objective:
      In recent years, there has been considerable discussion over the usefulness of national economic accounts such as Gross National Product (GNP), Gross Domestic Product (GDP), and Net National Product (NNP) in gauging economic growth and its contribution to social welfare. The most noted shortcoming of these account measures is their failure to explicitly recognize the contribution of the environment to economic welfare. Numerous suggestions for revising or supplementing the existing set of national economic accounts are found in the literature. Also found in the literature are theoretical papers on interpreting adjusted accounts in terms of their ability to reflect economic welfare. A feature of these papers is the maintained assumption that consumption choices are made optimally within an optimal control framework. Thus, welfare analysis is centered around the optimal consumption and investment paths. When considering the development and consumption of nonrenewable resources for which markets are competitive, this assumption is somewhat plausible. However, when considering environmental resources that may be roughly characterized as public goods, the optimal path assumption is implausible. The complex nature of public goods analysis precludes both static and dynamic efficiency. This project provides an analysis of account adjustments for environmental goods that are public in nature.

      The research approach applied in this project consists of the development of several economic models. First, a very simple economic model is developed and used to analyze the suggested practice of deducting expenditures dedicated toward environmental improvement. A second model is developed using economic preference theory to determine the environment's contribution to economic welfare. The model has two prominent dynamic features that influence the allocation of resources. First, manufactured capital stock, net of depreciation, carries over into future periods and determines future production possibilities. Second, the stock of environmental goods, net of depreciation, also carries over into future periods and provides service flows that contribute to production and consumer welfare. An ideal economic account, similar to those found in the theoretical literature, is developed using the maximum principle. The ability of the ideal economic account to accurately reflect changes in economic welfare is examined under assumptions of both optimal and suboptimal choice regimes. A final optimal control model is developed parallel to the second model that explicitly recognizes the importance of population in relation to environmental goods, which are public goods.

      Summary of Findings:

      Using a very simple model, the suggestion that expenditures dedicated to improving the environment be deducted from national economic accounts is shown to send the wrong signal when environmental improvements are welfare enhancing. The analysis indicates that deducting these expenditures will provide a disincentive for improving the environment and, therefore, runs counter to the objective of account reformers.

      Using the ideal account developed from the optimal control framework, the information required in implementing the ideal account is shown to be considerable. Adjustments come in the form of additions for current values of environmental flows and stocks as well as values for changes in environmental stocks. Under a regime of optimal choices, the ideal account has a meaningful welfare interpretation. However, once nominal prices are allowed to enter, comparisons of welfare must rely on Hicksian comparisons, which require both price and quantity information for the respective periods considered in the comparison. A major contribution of this research is the consideration of the ideal account under a more realistic suboptimal choice regime. The ideal account is shown to facilitate accurate Hicksian comparisons of current utility, as opposed to welfare that reflects future considerations, once the value of stock changes are subtracted. However, there exists a fundamental problem of inferring the wrong price for changes in the environmental stock under the suboptimal choice regime. This problem leads to the result that Hicksian comparisons of the ideal account will provide comparisons that are relative to the inferred price on stock changes as opposed to the price associated with an optimal choice regime. The degree to which the inferred price on stock changes differs from the price associated with the optimal choices depends upon the marginal relationship between resources dedicated to improving the environmental stock and the stock change.

      Allowing for population growth has interesting implications for the ideal account and any Hicksian comparisons. If the environment is roughly a public good, then there exists a fundamental asymmetry between the value of environmental and manmade resources. The vertical summation property implies an increasing aggregate marginal value under population growth for a fixed level of the environmental resource. The aggregate ideal account will not allow for meaningful Hicksian comparisons. Adjusting the ideal account into per capita terms essentially provides a new set of prices that do allow for Hicksian comparisons of the ideal account across time. With this adjustment, the earlier results can be applied.

      Conclusions. It is a fact that often-cited measures of economic progress such as the GNP and GDP do not meaningfully account for the contribution of the environment to economic welfare. Thus, considering these traditional measures as indicators of economic progress may be misleading public policies toward the environment and, in the end, resulting in welfare losses for both current and future generations. The construction of new and truly improved accounts, where improvement is measured by the ability of these accounts to accurately reflect welfare changes, is a task that requires careful deliberation.

      Actions such as deducting expenditures for environmental improvement on the grounds they are a cost of doing business may, in fact, have unforeseen and undesirable consequences. Using economic theory as a guide leads to a more complicated set of accounts given the information needed to make meaningful welfare comparisons. Account reformists must take heed that theoretically consistent accounts require both additions and subtractions to standard economic accounts such as GDP. Theoretically consistent, ideal accounts, should also be viewed with caution. In order for the ideal account to provide information on changes in welfare, price adjustment issues related to population and changing relative prices must be addressed. Even once these prices are accordingly adjusted, there will be cases in which the direction of economic welfare, up or down, simply cannot be determined.

      Publications/Presentations:

      Flores NE. Environmental values and national economic accounts: a theoretical inquiry. Discussion paper 983 presented to the Department of Economics, University of Colorado, Boulder, CO, 1998.


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