Posts

A Question of Scarcity

by Andrew Fanning

Andrew Fanning‘Tis the season for untold numbers of undergraduate students around the world to receive their first exposure to “Principles of Economics.” During the first couple of lectures, economic terms and concepts are thrown at impressionable young minds at a dizzying pace: opportunity costs, rational choice, marginal change, market economies, and the mother of them all, scarcity.

The conventional economic meaning of “scarcity” appears on the first page of virtually every first-year economics textbook. Here’s the version from the textbook I use: “Although we have boundless wants, our resources are limited.” The perceived battle between unlimited wants and limited means forces us to make tough choices about how to manage scarce resources. Conventional economists assure us that their “science” provides the proper instructions for making these tough choices. Thus, the “scarcity principle,” besides having intuitive appeal, provides the justification for the very existence of neoclassical economics.

The scarcity principle, however, is just an assumption, and it appears to be a dangerous one. Maybe in the empty world of the 18th century classical economists, it was mostly harmless to assume that people have unlimited wants because the vast majority of people had so little. But now that we live in a full world where the global economy is bumping against ecosystem limits, it’s time for economists to stop assuming that everyone always wants more and start accepting that it’s possible to have too much.

Still, questioning the relevance of scarcity in driving human behavior is a no-no in a conventional economics class. The student doing the questioning is likely to be shut down by the accursed phrase, “That’s not economics.”

The first reason why it’s tough to argue the point with conventional economists is that they only concern themselves with the scarcity of resources relative to other resources in a market, neglecting the reality of absolute scarcity. Philip Lawn shows the difference between relative and absolute scarcity clearly by asking, on the one hand, what happens to the price of a non-renewable resource like oil as the stock is depleted? Most people see that stock depletion leads to an increase in absolute scarcity and predict that the price would increase. On the other hand, he asks, what will happen to oil prices if OPEC significantly increases extraction rates and floods the market? Here, most people would predict that the price of oil would decrease as the increased flow of oil makes it less scarce relative to substitutes like coal. Of course, these scenarios are two sides of the same coin. In an empty world, the flow effects of relative scarcity on prices have dominated the stock effects of absolute scarcity, but this cannot continue indefinitely on a finite planet. In his book, Steady-State Economics, Herman Daly writes:

Absolute scarcity increases as growth in population and per capita consumption push us ever closer to the carrying capacity of the biosphere. The concept presupposes that all economical substitutions will be made. While such substitutions will certainly mitigate the burden of absolute scarcity, they will not eliminate it nor prevent its eventual increase.

If there is no choice to substitute one scarce resource for another, then there is no relative scarcity, and conventional economists will often concede the point, holding that such a situation lies outside the domain of economic analysis. Without choices it’s easy, they say — you just do what you gotta do. It’s not big-E economics. Case closed.

Dry Lake Bed with Cattle Skeleton

Neoclassical notions of scarcity differ from the absolute scarcity seen in a full world (credit Kiel Bryant).

A second reason it’s hard to argue with conventional economists about scarcity is because they disregard two features of human behavior. The first feature is that people prioritize some wants above others. Economists often ignore the fact that some goods and services are fundamentally more important and sought earlier than others. No, they cry, this would introduce unacceptable value judgements to our “positive” theory! As John K. Galbraith wryly noted, “Nothing in economics so quickly marks an individual as incompetently trained as a disposition to remark on the legitimacy of the desire for more food and the frivolity of the desire for a more expensive automobile.” The second behavioral feature is susceptibility to advertising and other marketing techniques. Despite the omnipresent sheen of the $500 billion global advertising industry sparkling on modern society, mainstream economists maintain that consumers know exactly what they want because, well, they just do. It’s not big-E economics if people don’t know what they want. Case closed. Again.

Economists often make strange assumptions about the scarcity of resources, but maybe their assumption about wants is stranger. Do people actually have unlimited wants, and has anyone bothered to test this hypothesis? Toward an answer, I recently came across a couple of studies that provide compelling evidence demonstrating people don’t have unlimited wants ingrained in their DNA.

The first is a fascinating book edited by John Gowdy titled Limited Wants, Unlimited Means about the economics of nomadic hunter-gatherer societies. As the title makes abundantly clear, the authors argue that our society of mass consumption has much to learn from members of these highly mobile societies who do not want to carry material possessions beyond those which they can make and replace from resources readily available.

The second study is an experiment whereby researchers team up with a Chinese fast-food restaurant in the United States to test a number of strategies for reducing calorie consumption among unsuspecting customers. They find that a much better strategy than calorie labeling is to simply ask people if they would like to “down-size” their meals during the ordering process. In particular, the researchers found that more than 30% of customers accepted the opportunity to receive less food, regardless of whether or not they received a discount! Although this result does not reject the unlimited wants hypothesis outright, the question of why calorie labelling is less effective than a verbal offer cannot be explained under neoclassical assumptions.

An alternative explanation is that people have difficulties controlling themselves. The best part of the fast-food study is that a substantial portion of customers readily recognized that they wouldn’t be able to stop consuming food once it had been placed on their plates, so they opted for less when given a nudge at a strategic point in their consumption decision. Clearly, finding these strategic points to encourage “right-sized” consumption is an urgent challenge on a full planet. Hopefully researchers can help us find more of them.

Andrew Fanning grew up on the blustery east coast of Canada where he eventually earned a master’s degree in economics. His interests include lots of things, especially the capacity of the planet to support life.

Sustaining Our Commonwealth of Nature and Knowledge

by Herman Daly

Herman DalyLet’s start with this phrase: “sustaining our commonwealth.” By sustaining, I don’t mean preserving inviolate; I mean using, without using up. Using with maintenance and replenishment is an important idea in economics. It’s the very basis of the concept of income, because income is the maximum that you can consume today and still be able to produce and consume the same amount tomorrow – that is, maximum consumption without depleting capital in the broad sense of future productive capacity. By commonwealth, I mean the wealth that no one has made, or the wealth that practically everyone has made. So it’s either nature – nobody made it, we all inherited it – or knowledge – everybody contributed to making it, but everyone’s contribution is small in relation to the total and depends on the contributions of others. In managing the commonwealth of nature, our big problem is that we tend to treat the truly scarce as if it were non-scarce. The opposite problem arises with the commonwealth of knowledge, in which we tend to treat what is truly not scarce as if it were.

Clarifying Scarcity

There are two sets of important distinctions about goods, and they make four cross-classifications (see figure below). Goods can be either rival or non-rival, and they can be either excludable or non-excludable. My shirt, for example, is a rival good because if I’m wearing it, you can’t wear it at the same time. The warmth of the sun is non-rival because I can enjoy the warmth of the sun, and everyone else can enjoy it at the same time. Rivalness is a physical property that precludes the simultaneous use of goods by more than one person. Goods are also excludable or non-excludable. That’s not a physical concept, that’s a legal concept, a question of property. For example, you could wear my shirt tomorrow if I let you, but that’s up to me because it’s my property. My shirt is both rival and excludable, and that’s the case with most market goods. Meanwhile, the warmth of the sun is both non-rival and also non-excludable. We cannot buy and sell solar warmth; we cannot bottle it and charge for it. Goods that are rival and excludable are market goods. Goods that are non-rival and non-excludable are public goods. That leaves two other categories. Fish in the ocean are an example of goods that are rival and non-excludable. They are rival, because if I catch the fish, you can’t catch it. But they are also non-excludable, because I can’t stop you from fishing in the open seas. The management of goods that are rival and non-excludable gives rise to the famous tragedy of the commons – or the tragedy of open-access resources, as it’s more accurately called. Now, the other problematic category consists of goods that are non-rival and excludable. If I use the Pythagorean Theorem, I don’t prevent you from using it at the same time. Knowledge is non-rival, but it often is made excludable through intellectual property and patent rights. So those are two difficult categories that create problems. One is the tragedy of the commons, and the other we could call the tragedy of artificial scarcity.

The Commonwealth of Nature

Fish in the ocean are an example of the commonwealth of nature. I’ll ague that natural goods and services that are rival and have so far remained non-excludable should be enclosed in the market in order to avoid unsustainable use. Excludability can take the form of individual property rights or social property rights – what needs to be avoided is open access. For dealing with the broad class of rival but, up to now, non-excludable goods, the so-called cap-auction-trade system is a market-based institution that merits consideration.

In addition to its practical value, the cap-auction-trade system also sheds light on a fundamental issue of economic theory: the logically separate issues of scale, distribution, and allocation. Neoclassical economics deals mainly with the question of allocation. Allocation is the apportionment of resources among competing uses: how many resources go to produce beans, how many to cars, how many to haircuts. Properly functioning markets allocate resources efficiently, more or less. Yet the concept of efficient allocation presupposes a given distribution. Distribution is the apportionment of goods and resources among different people: how many resources go to you, how many to somebody else. A good distribution is one that is fair or just – not efficient, but fair. The third issue is scale: the physical size of the economy relative to the ecosystem that sustains it. How many of us are there and how large are the associated matter-energy flows from producing all our stuff, relative to natural cycles and the maintenance of the biosphere. In neoclassical economics, the issue of scale is completely off the radar screen.

The cap-auction-trade system works like this. Some environmental assets, say fishing rights or the rights to emit sulfur dioxide, have been treated as non-excludable free goods. As economic growth increases the scale of the economy relative to that of the biosphere, it becomes recognized that these goods are in fact physically rival. The first step is to put a cap – a maximum – on the scale of use of that resource, at a level which is deemed to be environmentally sustainable. Setting that cap – deciding what it should be – is not a market decision, but a social and ecological decision. Then, the right to extract that resource or emit that waste, up to the cap, becomes a scarce asset. It was a free good. Now it has a price. We’ve created a new valuable asset, so the question is: Who owns it? This also has to be decided politically, outside the market. Ownership of this new asset should be auctioned to the highest bidder, with the proceeds entering the public treasury. Sometimes rights are simply given to the historical private users – a bad idea, I think, but frequently done under the misleading label of “grandfathering.” The cap-auction-trade system is not, as often called, “free-market environmentalism.” It is really socially constrained, market environmentalism. Someone must own the assets before they can be traded in the market, and that is an issue of distribution. Only after the scale question is answered, and then the distribution question, can we have market exchange to answer the question of allocation.

Another good policy for managing the commonwealth of nature is ecological tax reform. This means shifting the tax base away from income earned by labor and capital and onto the resource flow from nature. Taxing what we want less of, depletion and pollution, seems to be a better idea than taxing what we want more of, namely income. Unlike the cap-auction-trade system, ecological tax reform would exert only a very indirect and uncertain limit on the scale of the economy relative to the biosphere. Yet, it would go a long way toward improving allocation and distribution.

The Commonwealth of Knowledge

If you stand in front of the McKeldin Library at the University of Maryland, you’ll see a quotation from Thomas Jefferson carved on one of the stones: “Knowledge is the common property of mankind.” Well, I think Mr. Jefferson was right. Once knowledge exists, it is non-rival, which means it has a zero opportunity cost. As we know from studying price theory, price is supposed to measure opportunity cost, and if opportunity cost is zero, then price should be zero. Certainly, new knowledge, even though it should be allocated freely, does have a cost of production. Sometimes that cost of production is substantial, as with the space program’s discovery that there’s no life on Mars. On the other hand, a new insight could occur to you while you’re lying in bed staring at the ceiling and cost absolutely nothing, as was the case with Renee Descartes’ invention of analytic geometry. Many new discoveries are accidental. Others are motivated by the joy and excitement of research, independent of any material motivation. Yet the dominant view is that unless knowledge is kept scarce enough to have a significant price, nobody in the market will have an incentive to produce it. Patent monopolies and intellectual property rights are urged as the way to provide an extrinsic reward for knowledge production. Even within that restricted vision, keeping knowledge scarce still makes very little sense, because the main input to the production of new knowledge is existing knowledge. If you keep existing knowledge expensive, that’s surely going to slow down the production of new knowledge.

In Summary

Managing the commonwealth of nature and knowledge presents us two rather opposite problems and solutions. I’ve argued that the commonwealth of nature should be enclosed as property, as much as possible as public property, and administered so as to capture scarcity rents for public revenue. Examples of natural commons include: mining, logging, grazing rights, the electromagnetic spectrum, the absorptive capacity of the atmosphere, and the orbital locations of satellites. The commonwealth of knowledge, on the other hand, should be freed from enclosure as property and treated as the non-rival good that it is. Abolishing all intellectual property rights tomorrow is draconian, but I do think we could grant patent monopolies for fewer “inventions” and for shorter time periods.


Thermodynamic Roots of Economics

by Herman Daly

The first and second laws of thermodynamics should also be called the first and second laws of economics. Why? Because without them there would be no scarcity, and without scarcity, no economics. Consider the first law: if we could create useful energy and matter as we needed it, as well as destroy waste matter and energy as it got in our way, we would have superabundant sources and sinks, no depletion, no pollution, more of everything we want without having to find a place for stuff we don’t want. The first law rules out this direct abolition of scarcity. But consider the second law: even without creation and destruction of matter-energy, we might indirectly abolish scarcity if only we could use the same matter-energy over and over again for the same purposes — perfect recycling. But the second law rules that out. And if one thinks that time is the ultimate scarce resource, well, the entropy law is time’s irreversible arrow in the physical world. So it is that scarcity and economics have deep roots in the physical world, as well as deep psychic roots in our wants and desires.

Economists have paid much attention to the psychic roots of value (e.g., diminishing marginal utility), but not so much to the physical roots. Generally they have assumed that the biophysical world is so large relative to its economic subsystem that the physical constraints (the laws of thermodynamics and ecological interdependence) are not binding. But they are always binding to some degree and become very limiting as the scale of the economy becomes large relative to the containing biophysical system. Therefore attention to thermodynamic constraints on the economy, indeed to the entropic nature of the economic process, is now critical — as emphasized by Nicholas Georgescu-Roegen in his magisterial The Entropy Law and the Economic Process (1971).

Why has his profound contribution been so roundly ignored for forty years? Because as limits to economic growth become more binding, the economists who made their reputations by pushing economic growth as panacea become uncomfortable. Indeed, were basic growth limits recognized, very many very prestigious economists would be seen to have been very wrong about some very basic issues for a very long time. Important economists, like most people, resist being proved wrong. They even bolster their threatened prestige with such pretension as “the Sveriges Riksbank Prize in Economic Science in Memory of Alfred Nobel” — which by journalistic contraction becomes, “the Nobel Prize in Economics,” infringing on the prestige of a real science, like physics. Yet it is only by ignoring the most basic laws of physics that growth economics has endured. Honoring the worthy contributions of economists should not require such flummery.

I once asked Georgescu-Roegen why the “MIT-Harvard mafia” (his term) never cited his book. He replied with a Romanian proverb to the effect that, “in the house of the condemned one does not mention the prosecutor.”

Opportunity Cost of Growth

by Herman Daly

Economics is about counting costs, and the cost to be counted is “opportunity cost,” arguably the most basic concept in economics. It is defined as the next best alternative to the one chosen, in other words, as the best of the sacrificed alternatives. You chose the best alternative, the opportunity cost is the second best, the alternative that you would choose if the best were unavailable. If there were no scarcity, choice would not be necessary, there would be no opportunity cost, and economics would not exist. More of everything means opportunity cost is zero, and is essentially the denial of economics. Yet “more of everything” is the goal of so-called “growth economics.” When the whole economy grows, the growth economists say that we get more of everything. Is there an opportunity cost to the growth of the whole macroeconomy? Not in the view of mainstream macroeconomists. In their view the economy is the Whole and nature (mines wells, grasslands, fisheries, forests…) are Parts of the economy. Used up parts can be substituted by new parts; natural parts can be substituted by manmade parts; natural resources can be substituted by capital. The whole macroeconomy is not itself seen as a subsystem or part of a larger but finite ecosystem, into which the macroeconomy grows and encroaches. These economists imagine that the macroeconomy grows into the void, not into the constraining biophysical envelope of the ecosystem. Since macroeconomic growth is held to incur no opportunity cost (the displaced void is worthless!), one must conclude that “growth economics” is really not economics – it is almost the negation of economics!

Almost – there is one remaining bit of scarcity. Growth economists recognize that we can’t have more of everything instantaneously. To get more of everything we must invest and wait. The opportunity cost of investment is forgone present consumption. But it is a temporary cost. Later we will have more of everything, and after that still more of everything, etc. Is there no end to this? Not for the standard macroeconomists. In their view it might be possible to grow too fast, but never to get too big. That is, the opportunity cost of investment needed for rapid growth might be too high in terms of forgone present consumption. But that misallocation is temporary and will soon be washed away by growth itself that will give us more of everything in the future – more consumption and more investment. That is the growth economist’s theory.

However, increasing takeover of the ecosystem is the necessary consequence of the physical growth of the macroeconomy. This displacement is really a transformation of ecosystem into economy in physical terms. Trees are physically transformed into tables and chairs; soil, rain, and sunlight are physically transformed into crops and food and then into people; petroleum is physically transformed into motive force, plastics, and carbon dioxide. Thanks to the law of conservation of matter-energy, the more matter-energy appropriated by the economy, the less remains to build the structures and power the services of the ecosystem that sustains the economy. Thanks to the entropy law, the more dissipative structures (human bodies and artifacts) in the economy, the greater the rates of depletion and pollution of the remaining ecosystem required to maintain the growing populations of these structures against the eroding force of entropy. These are basic facts about how the world works. They could plausibly be ignored by economists only as long as the macroeconomy was tiny relative to the ecosystem, and the encroachment of the former into the latter did not constitute a noticeable opportunity cost. But now we live in a full world, no longer in an empty world – that is, in a finite ecosystem filled up largely by the economy. Remaining ecosystem services and natural capital are now scarce and their further reduction constitutes a significant opportunity cost of growth.

The new economic question is: Are the extra benefits of physically transforming more of the ecosystem into the economy worth the extra opportunity cost of the ecosystem services lost in the transformation? Has the macroeconomy reached, or surpassed, its optimal physical scale relative to its containing and sustaining ecosystem? Is the economy now too big for the ecosystem from the point of view of maximum human welfare? Or from the point of view of all living species and the functioning of the biosphere as we know it? If these questions about the opportunity costs of growth sound too abstract, think of the following concrete examples: wholesale extinction of species, climate change, peak oil, water scarcity, topsoil loss, deforestation, risks from more powerful technologies, a huge military to maintain access to world resources, and an increase in the risk of wars over resources, etc.

As the marginal costs of growth have increased, what has happened to the marginal benefits? Studies in the U.S. and other countries show that, beyond a threshold of sufficiency, growth in real GDP does not increase happiness. In sum, growth has become uneconomic at the margin, making us poorer, not richer. Uneconomic growth leads to less available wealth to share with the poor, not more. And such growth in the U.S. in recent years has been accompanied by increasing inequality in the distribution of income and wealth – that is, the marginal benefits of growth have gone overwhelmingly to the rich (third cars and second homes) while the marginal costs (polluted neighborhoods, unemployment and foreclosures) have gone mainly to the poor.

Surely economists have thought about such simple and basic questions as, Can the economy be too big in its physical dimensions relative to the ecosystem? And, Are the marginal costs of growth now larger than the marginal benefits? Surely economists have good answers to these obvious questions! Well, dear reader, I invite you to ask these questions to your favorite economics professor or pundit. If you get reasonable answers, please share them with me. If you get a lot of obfuscation, consider telling the economist to go to hell. Be open to learn – but also be prepared to show some disrespect when it is deserved!