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Imagining Externalities: Materials Balance and the Environmental Economics Literature

Marca Weinberg Economic Research Service, USDA

And

Stephen C. Newbold

Department of Environmental Science and Policy, University of California, Davis

May 7, 2002

Paper prepared for the World Congress of Resource and Environmental Economists, Monterey California, June 2002. The views expressed are those of the authors and do not necessarily reflect those of the U.S. Department of Agriculture.

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Imagining Externalities: Materials Balance and the Environmental Economics Literature

Externalities are pervasive! It’s not a very shocking statement. How about this one:

externalities are inherent in production and consumption processes? Of course they are! It’s

difficult to imagine a production activity that doesn’t involve the joint production of a negative

externality. What undergraduate environmental economics course does NOT matter-of- factly

introduce the concept of externalities? But this wasn’t always such an obvious concept, and in

fact, it’s not obvious today.

In their seminal paper, Ayres and Kneese (1969) went to great lengths to convince a

(presumably) skeptical reader that externalities were/are indeed pervasive. Today it’s hard to

imagine NOT thinking that such a thing is true, but try, if you will, to put your perspective back

to a time when you didn’t think that way, when externalities were treated as special cases in a

two-actor world. That’s the context in which Kneese and his coauthors (including Ayres,

d’Arge, and Bower, among many others) imagined what we all now know to be true.

So, we all know that externalities are pervasive. On the other hand, the “fact” as we

know it, is actually not what they had in mind. Sure, we can think of literally dozens of

production externalities at the drop of a hat. When I say “externalities are pervasive, and they’re

inherent,” how many of you think “sure, externalities are everywhere.” But when I say

“consumption” how many of you imagine something actually being consumed? Kneese and

company didn’t imagine that at all. They imagined consumption as simply a transformation of

matter. And, they imagined externalities that are a necessary outcome of all production and

consumption processes.

The 30 plus years since Ayers and Kneese published their seminal paper has yielded

something of a paradox. By most measures that paper was path-breaking. In 1979, it was the

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recipient or the inaugural AERE Publication of Enduring Quality Award, arguably the highest

honor awarded by this association. Its co-award winner that year was the much more well

known work by Harold Hotelling on exhaustible resource extraction. Since 1969, the Ayers and

Kneese paper has been cited 178 times, while a significant number, it is still significantly below

the value one might expect. Moreover, 51 of those cites, more than 25%, occurred in the past 5

years. Therein lies the paradox; that seminal paper is not particularly well known.

This paper explores that paradox. We start by considering the contribution of the paper

and the associated body of work. In doing so, we focus both on the findings and on the

contribution to subsequent literature, keeping in mind the underlying, nagging question, why

isn’t it more well known? Finally, we attempt to glimpse the future, and find a much stronger

link to the foundation laid 30 years ago than we have seen in the intervening years.

I. The RFF Analysis

Researchers associated with RFF’s Quality of the Environment Division, under the helm

and visionary influence of Allen Kneese, developed a comprehensive program of analysis of

residuals management that in many ways was decades ahead of its time. While forming a single

comprehensive program, it is convenient, for the purposes of this paper, to identify three related

but distinct strands in their early work: characterizing externalities, development of a materials

balance framework, and development and use of water quality process models.

a. Externalities are Pervasive

The early externalities literature focused almost exclusively on bilateral externalities, and

treated them as a special case of the standard economic models. The policy recommendations

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arising from that framework centered on the role of bargaining for resolving any efficiency

losses and focused debate on the role of property rights and transaction costs (e.g., Coase, 1960).

The approach taken by Kneese and his coauthors is a clear departure from that perspective. In

fact, Ayres and Kneese (A&K) and Kneese, Ayres, and d’Arge (1970) (K,A&D) devote

significant attention to distinguishing their approach from that in the previous literature. As they

point out, that early literature includes descriptions of consumption and production externalities

as “exceptional” and “uninteresting,” respectively (Sciotovsky) at worst, and at best focus on

variations on a theme of bilateral negotiation and development of property rights (e.g., Coase

1960, Buchanan and Tullock 1962, Davis and Winston 1962, and Turvey 1963), the solution to

which could return the economy to pareto optimality.

A&K use an expanded Walras-Cassel general equilibrium model, with Leontief

production technology assumed throughout, to demonstrate the pervasive nature of residuals

from (virtually all) economic activities. Materials balance requirements are added to the

standard model to derive expressions for residual flows to the environment as a function of final

goods demanded. Though it wasn’t fully exploited in this original paper or in Kneese’s later

work, the general equilibrium framework places the residuals problem squarely in the most

complete (conceptual) economic model standard in the literature – one in which all production

processes are (potentially) connected (through the Leontief input-output matrix), and

consumption and production decisions (and therefore levels of residual flows) are all determined

simultaneously.

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Kneese (1971) described this “new” approach as “the management of common property

resources approach” (emphasis in original).1 Two points are significant here. First is the

change in focus from independent action by the injured parties — a diffuse populace, each

bearing an unknown cost of an aggregate externality is significantly less likely to enter into an

efficient form of Coasian bargaining. Second, the focus necessarily shifts to one that is

inherently interdisciplinary. The social costs of disposal to an open access resource depend in

part on the extent of emissions relative to the assimilative capacity of that resource.

This approach emphasizes the pervasiveness of externalities and pollution problems. The

increasing prominence of air and water quality problems in the public psyche form the setting

within which they were operating. The oil-soaked Cuyahoga River in Ohio caught fire in 1969

and became a national poster-child for an environmental movement that was quickly gaining

steam. Environmental legislation was gaining renewed emphasis and real teeth. The 1965 Water

Quality Act was the nation’s first real attempt to regulate individual discharges and establish

ambient environmental (water-quality) standards. The 1967 Air Quality Act similarly

established authority to establish ambient air quality standards. Both acts were given more teeth

with amendments in the early 1970’s—the 1972 Water Pollution Control Act Amendments

(commonly referred to as the “Clean Water Act”) and the 1970 Clean Air Amendments (known

as the “Clean Air Act”). The U.S. Environmental Protection Agency was formed in 1970, as

K,A&D went to press. Notably, the work of Kneese, Ayres, and d’Arge first appeared in a report

to Congress. No longer could economists focus on a single factory and laundromat, sparks in a

field, or bees and apples and remain policy relevant.

1 The “common property” Kneese is referring to is more accurately referred to as public goods (or bads) in today’s parlance, which distinguishes common property as those resources that are commonly managed by a subset of the populous. Implicitly, exclusion of another set of the population is possible. Examples include some grazing commons and irrigation projects (e.g., Ostrom).

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This perspective also suggested a new focus for policy tools. Pigouvian taxes, though

clearly not new, gained increased attention. Analysis of the potential efficiencies associated with

“command and control” policies evolved from this starting point, as did an entire literature

focused on tradable pollution permits (discussed below).

Arguably, the explicit recognition of externalities as pervasive in the economy was the

single most important contribution of this body of research. The entire environmental economics

literature set off in a new direction after this paper was published. Though certainly other

influences were also at work, it clearly had an important influence on the path that was taken. It

can be argued that this line of inquiry was the benchmark that initiated environmental economics

as an independent field of study. 2

As important as this realization was, and as significant their influence, Kneese and his

coauthors received relatively little attention in the literature (see Figure 1). Certainly, the

number of citations for Ayres and Kneese pales in comparison to its impact. An initial flurry of

cites between 1970 and 1975 principally focused on their “new” concept for externalities.

Thereupon ensued a 20-year period--encompassing the heyday of environmental policy and the

emergence of the field of environmental economics--that saw only limited acknowledgement of

this important work. As discussed below, the recent increase in citations coincides with the

emergence of Ecological Economics – the journal and the field – and is more focused on the

materials balance aspects of the article.

So, we offer one hypothesis as to why more authors did not cite Ayres and Kneese

between 1975 and 1995: in the five years subsequent to publication, the idea that externalities

2 Perhaps as important as the contributions of their own research to the field of environmental economics, was Kneese and d’Arge’s contribution to the development of research outlets. Kneese and d’Arge co-founded JEEM, and both were on the original editorial advisory board for Ecological Economics. In addtion, Kneese was instrumental in the founding of both the Natural Resources Journal and Water Resources Research.

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are pervasive became such an engrained concept that it was taken for granted. Surely such an

obvious concept does not need a citation! No environmental or resource economist writing today

would imagine having to justify the importance of analyzing externalities, per se, or a conceptual

approach that involves an aggregate, public-good type of externality. This is not to say, of

course, that externalities are pervasive in the literature; “main-stream” economists, and

economics journals, routinely ignore environmental implications of economic activity.

b. Externalities are Inherent

The thought that externalities are pervasive was just the starting point for Ayers and

Kneese. They extend the idea to its logical extreme: residuals are a necessary outcome of all

production and consumption activities. A&K rely on the first law of thermodynamics—mass

balance—to make their case. Though presented in A&K, its complete development is found in

K,A&D. After briefly summarizing the conventional thinking with regard to externalities in the

economics literature, the authors lay out the thesis of their book:

“It is the main thesis of this book that at least one class of externalities – those associated with the disposal of residuals resulting from modern consumption and production activities – must be viewed quite differently. In reality they are a normal, indeed inevitable, part of these processes. Their economic significance tends to increase as economic development proceeds, and the ability of the natural environment to receive and assimilate them is an important natural resource of rapidly increasing value. We suggest below that the common failure to recognize these facts in economic theory may result from viewing the production and consumption processes in a manner which is somewhat at variance with the fundamental physical law of conservation of mass.” (Kneese, Ayres, and d’Arge, pps: 4-5.)

So the materials balance principle forms the foundation of their critique, or intended

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contribution, to standard economic theory. 3 The first half of the book is spent cataloging

residuals from all manner of production and consumption processes – from energy conversion

industries, to materials processing and production industries, to the household sector – perhaps in

an effort to convince the reader that, in fact, virtually all economic activities one can think of has

residuals associated with it, and they can be measured.

The second half of the book is an expanded version of the model originally presented in

A&K 1969. One of the main equations of interest in this section is the equation that gives the

total residual flows to the vector of final demands (equation 17 on page 81). Unfortunately, the

equation, which simply says that the total residual flow equals the total mass of raw materials

extracted minus the amount of final goods that are recycled, is excessively complicated, relative

to its usefulness. In the next section, we disaggregate that formulation to get an expression that

relates residual flows from production process as a function of the vector of final demands, but

even this approach is limited; to disaggregate further would require breaking down the

descriptions of the production technology into types of materials. For example, if one knew that

unrefined petroleum (a raw material) consisted of a parts carbon, b parts hydrogen, and c parts

sulfur, and that plastic widgets (a final product) consisted of x parts carbon, y parts hydrogen,

and z parts sulfur, and so on for all other goods flowing through the economy, then one could use

3 In fact, Ayres and Kneese have come to be synonymous with materials balance among economists. The MIT Encyclopedia of Modern Economics defines the “materials balance principle” as follows: “ In environmental economics, the principle whereby the amount of waste products discarded to the environment is held to be approximately equal to the withdrawal of resources to generate production of goods. In essence it is nothing more than the first law of thermodynamics: matter and energy taken form the environment (in the form of materials, fossil fuels etc.) cannot be destroyed and must, therefore, be disposed of some where (as gases, solid waste, liquids). …. Its importance for environmental management is that it demonstrates that waste generation is 'pervasive' to the economy. In turn, if the capacity of the environment to assimilate and degrade the waste into harmless form is limited, then externalities arising from the waste will also be pervasive. This is in marked contrast to the view that externalities are 'occasional' deviations from market perfection. The seminal article is R.U. Ayres and A.V. Kneese …”

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the materials balance approach to write equations relating the flows of carbon, hydrogen, and

sulfur from each production process.

Essentially contemporaneously, Leontief (1970) proposes a very similar model to the

input-output portion of the model presented in A&K 1969, but he assumes that technical

coefficients for residuals generation by production processes are determined (measured)

exogenously. Given these additional technical coefficients, he shows how they can be included

in the standard input-output analysis to determine changes in residual flows expected from

changes in final demand. Kneese used this extension in later applied versions of his model. 4

The difference between Leontief’s contribution here and A&K’s contribution in the 1969 article

is that A&K use a mass balance to derive the input-output coefficients for residuals generation

that Leontief assumes are measured exogenously. So, another perspective on A&K-K,A&D is

that they were trying to point out that given a standard input-output matrix for an economy, one

has all the information necessary to predict residuals generation from each process – assuming

that all coefficients can be converted to mass units and all relevant inputs and process are

accounted for in the matrix.

Also note that the A&K model measures residuals only, i.e. the total mass discarded to

the environment in the process of economic production. These need not be the same as

“pollutants,” i.e. residuals that cause environmental damage. Presumably this is why Leontief

starts with the assumption that the technical coefficients relating production to pollutants are

measured exogenously. If “pollutants” are a very small subset of “residuals,” then the mass

balance approach has much less utility – it can only provide upper bounds for pollutants. This is

a point to which we will return.

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Conceptually, this approach yields a general equilibrium perspective on production and

consumption. The policy implications are clear: opportunities exist for efficiency gains by

considering the stream of processes/control options. However, though the general equilibrium

approach is conceptually appealing, as a practical matter, the conventional modeling approach in

the environmental economics literature is a partial equilibrium one. Once again, the nagging

question, is why?

Mishan notes that externalities have always been analyzed in a partial equilibrium

framework. His only reference to Ayres and Kneese is in a footnote, which reads: “An

outstanding exception being the general equilibrium model produced by Ayres and Kneese. In

its present stage of development its heuristic advantages are more prominent.” We suspect both

statements are still true. Certainly examples of a general equilibrium approach to residuals

analysis fills the void that existed in 1971. But, while the general equilibrium approach to

analyzing interactions between externalities, and the implications for alternative policy

instruments that would arise as a result of these interactions, likely has not been pursued to its

fullest possible extent, the greatest value may be more conceptual. Deviations from a pure

general equilibrium or mass balance framework that are nonetheless true to the underlying

message is a contribution that cannot be underestimated.

Other examples of studies that follow, to some degree, the mass-balance approach

include those focused on solid waste management, those focused on the energy sector, and

extending more recently to analysis of climate change and linkages between greenhouse gas

emissions, energy use, and carbon sequestration, and a relatively new (or at least resurgent) body

4 See Herfindahl O, Kneese AV. 1973. Measuring social and economic change: benefits and costs of environmental pollution. In: The Measurement of Economic and Social Performance. ed Milton Moss. Columbia University Press, 441-508.

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of work in ecological economics attempting to link across economic and environmental

activities.

c. A new look at the old mass balance model

To, hopefully, make A,K&D’s mass balance model a bit more transparent, we develop a

highly stylized numerical example. We select a set of hypothetical coefficients and expand the

simple input-output model to a full general equilibrium model by specifying an aggregate utility,

or social welfare function, from which demand for outputs and supply of inputs can be derived.

An Input-Output Model of the Economy. Given the following input-output technical

coefficients:

=

=

45.02.015.03.04.01.0

15.025.05.0

5.175.01.15.20.25.1

C

a

Each intermediate commodity must be produced in sufficient amount to support production of

itself, other intermediate commodities, and final demand: X = CX + Y. Solving for X, we get:

[ ] [ ] YCIXYCIXYCXX 1−−=⇒=−⇒=− . Then, letting [ ] 1−−= CIA , we can see that

bYr = , where

==

677.7202.6743.5529.13765.11412.9

aAb . Notice that bYr

=dd

, so, for example, a

one-ton increase in the final demand for Y1 requires 9.412 more tons of r1. Applying mass

balance to the model yields the following for the residuals (E) from each sub-sector (k) in the

production sector:

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∑ ∑∑∑∑∑= = === =

−−+=N

j

N

jk

N

lljlkj

N

llkljk

M

i

N

llklilK YYACYACYAaE

1 1 111 1

(1)

A stylized schematic of this model is presented in Figure 2.5

From Equation (1) we can calculate the elasticities of each residual flow with respect to

each component of the vector of final demands (Yj). Table 1 shows that a change in demand for

good j will affect residual flows from the production of good j and all other goods. Also note

that it can be the case that the “cross-elasticity” is greater than a good’s “own-elasticity,” as seen

in row three of the table, where a percent increase in the production of Y3 yields a greater percent

increase in residual flow from production of Y1 than from the production Y3 itself. An initial

assessment of the utility of embarking upon this approach can been gleaned from Table 1; the

larger are the off-diagonal elasticities, particularly relative to the diagonal, own-effect, terms, the

more important will be an integrated assessment.

We can also use equation 1 to determine the Leontief coefficients relating residuals

directly to final demands, CE, where EkjC is the tons of residuals from production of k required to

support the production of one ton of j – analogous to the a matrix relating raw materials to

commodities, or to the b matrix relating raw materials to final demand. So,

==EEE

EEE

EEE

E

CCCCCCCCC

CdYdE

333231

232221

131211

5 Following the linkages in Figure 2 yields the following mass balance constraints, which obviously can also be derived from Equation (1):

Mass balance on sector X1: a11X1 + a21X1 + C21X1 + C31X1 = C12X2 + C13X3 + Y1 + E1 Mass balance on sector X2: a12X2 + a22X2 + C12X2 + C32X2 = C21X1 + C23X3 + Y2 + E2 Mass balance on sector X3: a13X3 + a23X3 + C13X3 + C23X3 = C31X1 + C32X2 + Y3 + E3

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Each element of CE is calculated as ( )

j

jk

Y

YE

∆

∆+Y, where the numerator is equation 1 evaluated

at Y plus an arbitrarily small increase in Yk. For example, EC12 is the result of evaluating equation

1 at k = 1 using

+

3

22

1

01.0Y

YY

Y

as the argument, and then dividing by 0.01Y2. So, for the above

example we get:

=

471.11735.5588.4588.4021.7781.2

147.4210.4786.6EC .

The elements of this matrix are interpreted as follows: Consumption of one ton of Y1 requires

6.786 tons of residuals from production of Y1 itself, 2.781 tons of residuals from production of

Y2, and 4.588 tons of residuals from production of Y3 – similarly for Y2 and Y3. The matrix CE

can now be used to calculate residual flows expected for any level of final demand: E = CEY.

General Equilibrium. To make what is essentially an input-output model into a full general

equilibrium model, we need to add equations for demand and supply to the system. Assume that

consumer preferences can be aggregated in such a way as to yield a Cobb-Douglas utility

function:

( ) ( ) ( ) ( ) θββαααθββααα −−−−−−−−−−= 2132121321 12121321 1111 EErrYYYU S (2)

Where the S superscript indicates that this is total aggregate utility, or “social welfare.” Notice

that E1 and E2 appear in the social welfare function, so choosing y’s to maximize this function

would yield the socially optimal level of consumption.

Along with this utility function are given technical coefficients relating raw materials

extraction to the production of outputs

bYr = (3)

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and technical coefficients relating emissions to outputs

YCE E= (4)

We can determine the optimal levels of consumption, raw materials extraction, and emissions by

substituting (2) and (3) into (1) and choosing Y1, Y2, and Y3 to maximize US. Let’s call these

optimal levels Y*, r* and E*. This is the solution that accounts for the disutility caused to some

people in society by emissions from production processes.

To determine the equilibrium levels of consumption, raw materials extraction, and

emissions, we need an alternative utility function that effectively incorporates only market

transactions, i.e. the aggregate utility arising from market exchanges of Y and r. Let us suppose,

for simplicity, that this function is:

( ) ( ) 2132121321 11 ββααα rrYYYU M −−= (5)

Where the M superscript indicates that this aggregate utility arising from market transactions.

Thus, the externality caused by emissions is UM – US. The equilibrium levels of Y, r, and E can

be determined by substituting (2) and (3) into (4) and choosing Y1, Y2, and Y3 to maximize UM.

Let’s call the market equilibrium values YEq, rEq, and EEq. The market clearing price ratios

(prices normalized by setting p1 = 1) can be determined by calculating the marginal rate of

substitution between each combination of arguments in the utility function. For example:

EQM

M

ppp

YUYU

21

2

1

2 ==∂∂∂∂

(6)

Prices for Y3, r1, and r2 are determined similarly.

One policy option for adjusting market output to equal the socially optimal levels is to

impose taxes on consumption and resource extraction sufficient to induce firms to produce less

output and demand fewer inputs. The effective price required to induce firms to produce at Y* as

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opposed to YEq (i.e., the price firms take, pEq – tY, where tY is the tax consumers pay on final

goods) is, for example:

YEqM

M

tpYUYU

221

2 −=∂∂∂∂

*Y

(7)

The left hand side of (6) is the marginal rate of substitution between Y2 and Y1 in the market

utility function, evaluated at Y*. Therefore the required taxes can be calculated as follows:

*EqYY 1

2

1

22 YU

YUYUYU

t M

M

M

MY

∂∂∂∂

−∂∂∂∂

= (8)

where the first term on the right hand side of (7) is the marginal rate of substitution between Y2

and Y1 evaluated at YEq. Taxes for Y3, r1, and r2 can be calculated in a similar fashion.

To provide a more concrete example if the potential advantages of the general

equilibrium approach to policy analysis, we turn to the question of what happens when a tax is

imposed on only one of the Y’s or r’s.6 Relying again on the stylized coefficients in the

numerical example above yields the results in Table 2. The last blocks of output in Table 2

represent a set of second best taxes, e.g., taxes on a single output, sufficient to induce consumers

to demand Y1* or Y2

* or Y3*, respectively. They provide an example of potential implications of

analyzing a problem with significant economy-wide linkages in a partial equilibrium

framework.7 Comparing across blocks, we see the substitution between Y’s (e.g. tax Y2

sufficiently to reduce demand to Y2* and demand for Y1 and Y3 go above the free market levels),

but emissions from all three processes go down in all cases. However, depending on the

6 Note that the Leontief nature of the model specification suggests that an equivalent specification exists for taxes on emissions, but that this symmetry will not generally exist. 7 Note, however, that even this analysis assumes the analyst is able to solve for the optimal solution, but then deviates from that solution in the policy analysis.

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functional specifications, it is possible that taxing only one output could induce substitution to

other goods sufficiently to increase emissions from their production. 8

A similar, but significantly more developed approach is taken by Vatn (1998). The

author first develops the materials balance approach alongside the now more familiar “standard

[analytical] formulation.” Vatn notes that a few others have also commented on the relationship

between these two approaches, but they generally only mention the materials balance approach

in passing, on their way to presenting their version of the standard formulation. The author then

attempts to show that “such implicit treatments of mass balance may lead to incorrect policy

recommendations.” The crux of the argument is that materials dispersion (actually the second

law of thermodynamics, not the first that refers to mass conservation) implies that “transaction

costs of internalizing the externalities” will be higher the later in the dispersion process the

regulation is undertaken, i.e., all else equal, a tax based on ambient levels of pollutants will be

more costly to implement than taxes on pollution generating inputs. Of course, a tradeoff exists

between putting a tax on the actual pollutant (argued to be more costly here, but otherwise more

effective), and taxing the inputs to the pollution generating process (less costly, but likely less

effective). The author then develops a (standard) model to illuminate this tradeoff.

To conclude, important insights arising from the general equilibrium, mass-balance

perspective include:

(i) Externalities are inherent in production and consumption activities, and share

characteristics with public goods. Moreover, the social cost of this class of

externalities is a function the quantity of residuals discharged relative to the

assimilative capacity of the natural resource to which it is emitted.

8 This perverse result is similar to that demonstrated by Plott (1966) for the case that output is taxed while in the presence of an inferior, polluting input, but is based on a different mechanism, e.g., a direct effect (reduced output)

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(ii) A mass-balance approach will be most useful where the mass of residuals is

proportional to the marginal social cost of discharge into the environment, and where

alternative pathways for disposal exist.

(iii) A general equilibrium approach will be welfare enhancing where the

efficiency/welfare gains of incorporating the marginal social cost of indirect

production effects in policy design is large relative to the additional cost of

information, or conversely, detail lost to the aggregation process potentially necessary

to implement a general equilibrium analysis.

Points (i) and (ii) cry out for integrated, multi-disciplinary analysis, blending economic

decision models with economic, physical and biological process models. The third point

suggests the need for care in selecting an economic framework. In summarizing their own main

points, KA&D also note that: “[External diseconomies] cannot be properly dealt with by

considering environmental media such as air and water in isolation.” (pg 14). Though it is not

clear that this conclusion derives explicitly from the presentation of their conceptual framework,

it is implicit and is intuitively correct. As compelling as this argument is, 30 years later the

literature on the control of multi-media pollutants is surprising sparse.

Despite the “correctness” of their arguments—we find no strong argument with any of

the above premises—Mishan appears to also have been prescient in emphasizing the heuristic

advantages of their approach. Indisputably, this body of work has “…serv[ed] as an aid to

that is offset by substitution to alternative outputs and by an indirect, endogenous production effect.

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learning, discovery, or problem-solving …” and provides a “…speculative formulation serving

as a guide in the investigation or solution of a problem” (American Heritage Dictionary)

Rather than arguing with the conceptual foundation, critiques of the “RFF approach”

focus on limitations of empirical analysis: in particular, the linear (or other) functional forms for

production functions, fixed consumption, production, and waste treatment technologies, and the

treatment of residuals vis a vis external diseconomies. Many of these arguments address in some

manner limitations arising from the need to simplify such a complicated framework to make it

conceptually and empirically tractable.

Noll and Trijonis (1971) provide a direct response to A&K 1969. They begin with this:

“The main point of their paper, that a general equilibrium analysis is required if the secondary

effects of pollution and pollution abatement strategies are to be given proper consideration, is

incontestable (although in certain specific instances the importance of secondary effects may not

be great enough to be worth examining).” They then note that “residuals” do not necessarily

equal “pollutants,” since not all residuals will cause damages, a point that Ayres and Kneese

would surely concede, but did not address in their paper. Also, the point to the assumption of

fixed “consumption technology” (the mass of final goods consumed are the arguments of the

utility function, not the services rendered), as foreclosing the possibility of rearranging

production to deliver the same amount of product service using less mass, and assert that the

Walras-Cassel general equilibrium model as amended by Ayres and Kneese cannot be used to

appropriately estimate (shadow) prices of residuals (which should be negative) unless the model

is changed; the authors then go on to suggest the required changes.

One early attempt to provide more context for environmental effects looked “upstream”

in the process. Wilen starts with the Leontief input-output portion of the Ayres and Kneese

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model (as do most extensions of the A&K model, including their own), and adds more matrices

that relate raw materials extraction to ecosystem functions (called here “eco-products,” e.g. net

primary productivity of different ecosystems). So the A&K model was expanded “backwards”,

i.e. farther into the environment from the raw materials extraction side of the economy. Effects

of residual flows back to the environment from the economy would be included by expanding

the vector of final demands to include demands for “disposal services;” the author goes on to

derive expressions for a number of “ecoimpact coefficients,” which indicate, for example, the

“relative extent to which an increase in final demand in industry j affects the total ecosystem.”

Perrings (1986) attempts to demonstrate that the principle of conservation of mass poses

serious “conceptual problems for general economic equilibrium” – that is in addition to the

problems of omission that A&K pointed out. The author identifies three inherent assumptions in

general equilibrium models – that technology is fixed, that resources can be costlessly exacted

from nature, and that residuals can be costlessly disposed off – and then argues that the

conservation of mass principle contradicts all three.

In a more recent example, van den Bergh (1999) focuses on whether or not standard

economic production functions (e.g. Cobb-Douglas, CES, etc.) are consistent with the principle

of conservation of mass, and offers new general functional forms to address this potential

problem. This is apparently an extension of Daly’s discussion of the Solow-Stiglitz model of

growth (Cobb-Douglas with capital, labor, and natural resources).9

A final issue potentially limiting adoption of the modeling approach is the rather extreme

policy implications that it generates. As K,A&D note, if the pervasiveness of externalities holds

true, “a nearly universal divergence (of greater or lesser degree) between prices and social costs

9 See Daly HE. 1997. Georgescu-Roegen versus Solow/Stiglitz. Ecological Economics 22:261-266; and the replies by Solow and Stiglitz in the same issue.

19

is implied.” Thus, the implied policy solution for achieving Pareto efficiency is a set of taxes

(or other policy instruments) applied to each and every activity in the economy. Even if it was

possible to quantify all necessary relationships economy-wide, the practical utility of an

analytical exercise yields a universal set of taxes is highly suspect.

Abstracting from the practical restrictions imposed from a “full-blown” replication of the

model set out in A&K and K,A&D, lies a middle ground of carefully constructed linked

economic, physical and/or biological process models. In fact, this is the approach taken in

Kneese and Bower who refer to the general equilibrium/mass-balance approach, but abandon it

rather rapidly in favor of regional environmental quality models that are at once more narrowly

focused from an economic perspective and significantly more complicated in the individual

processes included than would be allowed within a more general framework.

d. Integrating Economic and Environmental Process Model: Delaware Case Study

The Delaware Estuary ecosystem model is an integrated, watershed-scale set of linked

biological, physical and economic process models. It set a standard for such models that in many

ways would (or should) be the envy of any modeler today. The model includes:

• Two nutrients: nitrogen (N) and phosphorous (P)

• Biological processes/elements: algae, bacteria, zooplankton, fish, BOD, dissolved

oxygen, suspended solids, toxics, heat

• Discharges from municipal and industrial sources (including refineries, steel mills, power

plants, household heat, commercial heat, large industrial plants, sewage treatment plants,

paper plants, solid waste disposal (including incineration and disposal),

• Instream aeration

20

• A physical factor describ ing inflow and outflow

• An atmospheric dispersion model

• An aquatic ecosystem model.

Inputs thus spatially dispersed discharges of: BOD, N, P, toxics (phenols), and heat,

which, given underlying processes, yield as outputs: fish biomass, algal densities, and dissolved

oxygen. The model structure includes mass balance for N, P, and carbon (C). As a profession,

we’ve gotten better at characterizing some of the pieces, but have yet to substantially improve on

the model integration developed by Russell and Spofford.

Thanks to its high degree of spatial disaggregation and integrated process models, the

Delaware framework provided an ideal tool for assessing the efficiency costs of uniform policy

tools relative to least-cost and spatially zoned ones (Kneese and Bower 1968). While the

economic gains available from exploiting linkages between externalities and the spatial

configuration of waste discharges in the design of policy tools probably most recognized in the

vast tradable permits literature (discussed below), surely one of the lasting legacies of the RFF

work is the integration of spatially explicit environmental and economic models and their

application to innovative policy tools.

e. Discussion

Three review articles assessing the environmental economics literature have been

published in the Journal of Economic Literature (the premier source for review articles) in the 30

plus years since Ayers and Kneese (1969) was published (Mishan 1971, Fisher and Peterson

1976, and Crooper and Oates 1992). The contribution of Ayers and Kneese, and their mass

balance/general-equilibrium approach to modeling externalities, is relegated to a footnote in both

21

the first and last of these (i.e., Mishan and Cropper and Oates), but receives extensive attention

by Fisher and Peterson.

So, it appears that at some point between 1976 and 1992 the model presented by A&K

was effectively relegated to the backwaters of environmental economics theory. However, it

also appears that A&K may have been resurrected in ecological economics, in spirit if not in its

full-blown mathematical glory (except in the case of input-output analyses focused on

environmental questions). Environmental economics as of 1992 was much more focused on

analytical models of environmental policy instruments, and developing and testing advanced

non-market valuation methods. This is still largely true today, but it is interesting to note that the

current focus on climate change in environmental economics hearkens back to the early (late

60’s early 70’s) worries about limits to growth. Both are long-run issues where dynamics,

technological change (as well as preferential change), and uncertainty figure prominently (the

importance of uncertainty is a new addition to the analytical models though). The more recent

assessment of research trends in the field 10 identifies other areas of current interest as well,

including: in situ environmental benefits of natural resource stocks, the spatial pattern of natural

resource use, advanced econometrics for valuation studies, global externalities (e.g. climate

change), and spatial relationships and land use.

Returning now to the question we began with: why don’t more economists adopt (or at

least cite) this approach? Is the mass balance approach really just a useful heuristic? Part of the

answer must surely be that it is extremely difficult to implement. Taken to the extreme, the data

and computational needs would be overwhelming. Other practical concerns involve simplifying

assumptions necessary to make the problem tractable (as discussed above) and an assessment of

22

residuals that focuses on their mass, rather than on the social cost of that mass in its various

forms. For example, one ton of carbon emitted into the environment will generate a different

cost than one ton of nitrogen. Similarly, the social cost of one ton of nitrogen emitted to a

waterway in the form of organic N, implies a different cost than one ton of nitrogen emitted as

nitrous oxide, and yet another cost if emitted as ammonia.

Another answer probably can be attributed to the prevailing environmental institutional

and policy setting. Environmental regulation in the United States has long focused on regulatory

framework with uncoordinated policymaking; jurisdiction for implementing such important

federal legislation as the CWA, CAA, TOSCA, etc.) often ignored potential linkages as a matter

of law. Even the lead regulatory agency, is organized according to media; EPA’s organizational

chart contains an Office of Water, Office of Air, as well as offices devoted to particular classes

constituents, e.g., solid waste and pesticides and toxic substances. A single media/partial

equilibrium approach maps directly to that setting.

II. The Environmental Economics Literature: Heading down the Path

Reviews of the state of the environmental economics abound, and are beyond the scope

of this paper. See, for example, Cropper and Oates, for a detailed assessment and comprehensive

development of advances in the literature, and the collection of papers celebrating JEEM’s silver

anniversary (May, 2000) for significant trends and contributions. In contrast to traditional

review papers, which tend to focus on conceptual and methodological advances, we highlight

those strands of the literature, principally applications, that appear to have been influenced

(directly or indirectly) by the work of Kneese and his coauthors.

10 Deacon RT, Brookshire DS, Fisher AC, Kneese AV, Kolstad CD, Scrogin D, Smith VK, Ward M, Wilen J. 1998. Research trends and opportunities in environmental and natural resource economics. Environmental and Resource

23

Without commenting on the direction of causality, a recent, relative explosion of papers

embodying the mass balance approach appears to be highly correlated with advent of Ecological

Economics as an outlet for such work.

a. Applications Explicitly Incorporating Materials Balance Principles

While many economists actually apply mass balance principles in their research (as is

suggested in following sections), relatively few label it as such. A quick search of EconLit

reveals only 18 papers using materials or mass balance as key words, and of those fully half

include Robert Ayres as an author or editor. Nevertheless, some trends can be identified.

Explicit incorporation of materials (or mass) balance principles in economic analysis is much

more prevalent among European resource and environmental economists than in the United

States. The collection of papers in Ayres, Button, and Nijkamp (1999) reflects the continuing

interest in, and extensions (primarily dynamic specifications) of the basic approach. Empirical

applications tend to be concentrated in the following areas:

• Recycling and solid waste management (e.g., Huhtala 1999, Starreveld and Van Ierland1994)

• Sustainable consumption (e.g., Heiskanen and Pantzar 1997), development (e.g., van den

Bergh and Nijkamp 1994), and growth (e.g., Gross and Veendorp).

• Waste from chemical industries (e.g., Wolfgang and Ayres 1994, Ayres and Ayres 1994)

• Energy balance, climate change and carbon sequestration, and linkages to natural resource

management (e.g., Creedy and Wurzbacher and Korhonen, et al.) and international trade

(e.g., Machada, et al.)

Economics 11(3-4):383-387.

24

b. Life Cycle Analysis

A close relative to the “pure” materials balance approach (or perhaps as much a set of

“new clothes” for the emperor as a different modeling approach), “Life Cycle Analysis” (LCA)

has taken on a life of its own. The basic premise and application is a focus on the choice of the

"greener" of two products, essentially the common “paper or plastic?” quandary. To answer this

question from an environmental cost perspective it is necessary to follow both products from

“cradle to grave,” i.e., to assess the indirect and direct implications for the environment, as well

as the future (downstream) fate of a product. An obvious framework for such an analysis is the

general equilibrium/mass-balance approach, albeit one that emphasizes the role of process

models in describing linkages. Ayres (1993) provides an overview of the approach and, not

surprisingly, characterizes the role for input-output models within it.

Ackerman (1997) provides a detailed assessment of the life cycle tradeoffs in packaging,

recycling and disposal decisions, concluding that once the energy costs associated with reverse

transport and reprocessing are accounted for, disposable lightweight packaging for beverages is

preferred to cans or bottles, whether they are recycled or not. More recently, Walls and Palmer

develop a nice conceptual framework for considering optimal, and suboptimal policy tools for

reducing social costs of multiple avenues of waste discharge within a LCA framework.

c. Recycling and Solid Waste Management

More than any other application, the recycling and solid waste management literature

includes some notation of materials balance/life cycle analysis, or a general equilibrium

perspective.

25

The contributions of Ackerman (1997), Hutula1999, and Starreveld and Van Ierland1994 are

noted above. In addition, Keeler and Renkow (1994) model tradeoffs between three options for

municipal solid waste disposal: incineration, landfilling, and recycling.

Other important extensions two disparate approaches to design incentives for addressing

upstream and downstream waste disposal. Dinan (1991 and 1993) considers incentive based

approaches to encourage household recycling, while Eichner and Pethig (2001) adopt a general

equilibrium approach to examine efficient policy tools for addressing waste disposal in a linked

resource extraction, production, recycling, and treatment model.

d. Tradable effluent permits

That tradable effluent permits can generate the least cost solution to achieving an

environmental quality objective is a principal that is as central to an environmental economics

course as the supply and demand concepts are in a principles course. The primary intellectual

source for the underlying theory and its many extensions are generally attributed to Montgomery

and Tietenberg (see Baumol and Oates, Cropper and Oates and/or Tietenberg for an overview of

the development of this literature). Nevertheless, linkages to RFF surely exist. Kneese’s work

bringing externalities into the realm of acceptability among economists, if not to the forefront,

paved the way for exploration into various incentive-based policy tools that extended beyond the

traditional Pigouvian solution.

In addition, many of the most significant early advances in the tradable permit focus

explicitly on incorporation of spatial diffusion of discharges, implications of attaching permits to

emissions relative to ambient quality (e.g, Tietenberg, Atkinson and Tietenberg and McGartland

and Oates) and associated extensions. Researchers across the country were experimenting with

26

the development and integration of air and water dispersion models; the extensive and productive

efforts at RFF by no means had a corner on the market, but they were important players.

More recent extensions include those focused on dynamic markets (e.g, Kling), markets

for stock pollutants (other cites), and markets for pollution with multi-product, multi-pollutant

firms (Nagurney, et al.), as well as empirical studies of relatively new actual markets, such as the

U.S. SO2 market and markets for nutrients in Northern Europe.

e. Double dividend

A relatively new literature on the “double dividend” considers potential efficiency gains

arising from environmental taxes due the use of those revenues to offset other distortionary taxes

in the economy. While not directly linked to either the mass-balance or general equilibrium

frameworks described above, we mention it here because the explicit consideration of a

government budget constraint and linkages between environmental and “productive” sectors of

the economy through price-based policy instruments is yet another direction for extensions of the

general equilibrium perspective. In addition, perhaps coincidentally, the U.S. strand of this

literature has strong “next generation” RFF linkages (e.g., Ian Parry and Larry Goulder).

Bosello, et al., 2001, Parry and Oates (2000), Kahn and Farmer (1999), Bovemberg, Goulder,

among others, alternately suggest that such efficiency gains do or do not exist, and explore the

conditions under which they may or may not arise.

f. Non-market Valuation

Reviews of the non-market valuation literature abound (see, for example, Cropper and

Oates, or V.K. Smith (May 2000)). Moreover, a paper on RFF’s contribution to this literature

will be presented in the same session as this paper, and we refer the interested reader to that

27

paper. We do, however, mention it that literature at this point to emphasize the linkages to the

residuals management work that is the focus of this paper.

Kneese himself appears to have been drawn into the benefits estimation literature as a

necessary and natural counter balance to the cost-based policy analysis arising from the residuals

management work. Kneese (1984) discusses early experience with the travel cost method,

contingent valuation (called “bidding game surveys” in this book), epidemiological research on

the relationship between air pollution and human health, and hedonics (again, not called that

here). There is also mention from time to time in this book of the need for, and difficulty of,

interdisciplinary research. There is a section on “Links between actions affecting the

environment and their effects on humans,” which usually involve rather long chains of causal

mechanisms that go through at least one natural science discipline. In addition, “existence

values” was presented essentially as a new finding here, and with notice that, “surprisingly,”

existence values look as though they may be as big or bigger than use values.

Though it is not explicit, we also suspect that drive to develop benefit estimates may stem

from a desire to address the vexing concerns regarding potential or actual divergences between

residual mass and external diseconomies. Converting residuals to a dollar metric based on the

marginal social cost of their discharge would address that concern and close a tremendous gap in

the general equilibrium framework.

g. Do we or don’t we?

At first glance, and in many ways, the residuals management approaches developed at

RFF do not appear to be widely adopted by resource and environmental economists.

Nevertheless, the above discussion lays out a set of research areas that have been more or less

28

directly influenced by one or more aspects of the mass-balance and general equilibrium

approach. The vast literature on adapting and applying mathematical optimization techniques to

air and water quality analyses and the use of environmental process models contain clear direct

or indirect linkages to the Delaware modeling work.

Other lines of inquiry likely arise from an indirect influence or because they are logical

extensions along a path leading from a fork in the road long forgotten. These approaches may

include empirical estimates of costs of 2nd- (or Nth-) best environmental policies, incorporation

of spatial analysis tools into land use analysis, a surprisingly small, but growing literature

involving multi-media/multi-pollutant analysis, and interdisciplinary/integrated modeling

research efforts. The latter two cases were explicitly suggested by A&K and K,A&D but their

implementation was lagged noticeably relative to other advances. One possible explanation lies

in the truly pathbreaking nature of the concepts, and the large and sophisticated modeling and

technological requirements (e.g., computer clock speed and capacity) requirements for their

implementation. They may simply have been a generation ahead of their time in this respect.

III. New Directions: Back to the Future

In this section we provide two examples of research questions that simultaneously will

move the literature forward in terms of the complexity of the problem studied and of the

analytical approach, and harken back to the Kneese, et al., roots. In a sense coming full circle,

both in the literature and in this paper.

29

a. Animal Waste Management

Animal production produces organic material, nitrogen compounds such as urea,

ammonia and nitrous oxide, phosphorus, methane, carbon dioxide, pathogens, antibiotics, and

hormones. These materials can negatively affect the quality of surface water, groundwater, soils,

and the atmosphere, with the potential to distort markets and impose costs on society. And,

policy options for addressing one facet of the process can exacerbate (or improve) others. For

example, the preferred alternative to disposal of animal waste is to spread it on cropland at

agronomic rates, thereby also converting a waste problem to one of providing valuable nutrients

to crop production. The ultimate disposition of those nutrients depends on numerous factors

ranging from cropping patterns and yields, and thus nutrient uptake, the extent to which manure

is substituted for, rather than supplementing, commercial fertilizers, to the manner in which it is

spread. For example, nutrient losses from volatilization from land application are 5% if manure

is incorporated, but is 30% if it is surface applied. Physical field characteristics (e.g., slope and

distance to water ways) and climatic variables will also have a significant influence on the

nutrient loadings to waterways from surface runoff, or alternately, to groundwater aquifers from

leaching.

Another policy suggestion is to require all confined animal feeding operations (or all

those above a given size threshold) to install lagoons for storing animal wastes. These storage

systems volatilize nitrogen, thereby reducing the concentration of nitrogen in the lagoon effluent

and reducing potential impairments to water quality. However, the volatized nitrogen

compounds escape into the air creating odors, particulate matter (pm), greenhouse gases and

other cross media pollutants. Clearly, a materials balance approach is needed to better

30

understand the net environmental impacts of alternative management practices, and,

consequently, to evaluate alternative policy tools.

Treatment of animal waste in economics literatures is curiously consistent over time.

K,A&D note problems associated with animal waste as a natural, and potentially important,

application for their approach. Ashraf and Christensen (1974) provide an early assessment of the

costs of implementing environmental controls on livestock waste. Matulich, Carman and Carter

(1979) develop a systems approach to waste management from dairies, and note the potential for

efficiency losses if interdependencies between waste management and agricultural production

are ignored. However, an integrated conceptual model for livestock waste production and

management is a recent addition to the literature (Innes 2000).

Innes (2000) develops the most comprehensive conceptual model for animal waste

management in joint animal-crop produc tion system to date. Innes’ model is unique in that it

incorporates assimilative capacity (via a spatial component of the model of regional livestock

production) and three linked, but distinct avenues for waste to reach the environment: spills

from animal waste stores, nutrient runoff due to the application of manure to croplands, and

direct ambient pollution, including odors, pests, and gases. Fleming, Babcock, and Wang

(1998), provide an empirical analysis that considers a portion of those factors, e.g., they consider

alternative waste management strategies given alternate storage technologies, nutrients of

interest/concern, crop rotations, and incorporation techniques.

The intervening years between the early attempts to fashion linear systems approaches

and the more recent theoretical and empirical advances in integrated assessment saw a wide

range of advances focusing on a particular subset of the linkages in this very complicated system.

For example, Johnsen (1993) focuses on farm-level phosphorus emissions, while Klaassen

31

(1994) addresses ammonia emissions in a more aggregate, multi-country, framework. Schnitkey

and Miranda 1993 model emissions from a linked livestock-crop production system, while

Pennings, et al., 1996 consider interactions between a hypothetical futures market for

phosphorus from manure with marketable rights to livestock production. In one of the rare

papers that considers the reverse linkage, Ozsabuncuoglu 1996 focuses on the effect of municipal

and industrial waste in irriga tion water on crop and soil quality, human health, and the

environment.

Yet another line on inquiry focuses on modifications to feed rations and the use of

additives to reduce the nutrient content of animal waste, e.g., Boland, et al., (1999) and Bosch, et

al., (1998) for hogs and Bosch, et al., (1997) for poultry. For example, by increasing the

efficiency with which animals process nutrients, phytase may be effective in reducing the

phosphorus content of hog manure by as much 30% (Bosch, et al., 1998).

The implications for potentially large benefits from source control recalls an early

criticism of the A&K mass-balance approach, namely the tendency to rely on fixed coefficients

describing linkages, and relative difficulties associated with incorporating endogenous technical

change. The complicated nature of linked crop- livestock production systems, suggests that were

the analysis of animal waste management to have proceeded strictly down the path laid out by

A&K this potential efficiency gains associated with source control might have received less

attention.

This is not to say, however, that the A&K-K,A&D approach did not have an important

role to play in this literature. Indeed, the literature increasingly is moving in this direction.

While not typically pursuing a general equilibrium approach, empirical studies increasingly are

incorporating nutrient balances into linked economic-environmental models, and those studies

32

have only scratched the surface in terms of the potential avenues of inquiry possible with this

approach. Figure 3 presents a schematic representation of nitrogen balance from animal

production. Clearly, this is a multi-media, multi-pollutant problem, but has only rarely, and

partially, been analyzed as such.

Schwabe (2000 and 2001) provides perhaps the most comprehensive accounting of

nitrogen in an economic modeling framework to date. His primary focus is on the effectiveness

of alternative policies for addressing water quality problems associated with nutrient loadings to

the Neuse River in North Carolina. Although nutrients from livestock were not a control variable

in this problem, Schwabe demonstrates the importance of modeling loadings from livestock as

well as those from the sources of interest—agriculture and municipal point sources. Ignoring the

importance of that “background” source of nutrients has potentially large efficiency implications

for the regulated sectors. Shwabe’s work is also notable for the care with which he balances the

nitrogen linkages between crop activities and water quality, incorporating factors for crop

absorption, soil retention, leaching into groundwater, discharge to the stream edge and

dissipation between the stream entry point and the estuary. In the end, of 138 pounds applied to

the field, only 2.9 pounds reach the estuary in the example provided (Schwabe 2002, pg 47).

Schwabe’s efforts, and similar work tracing nitrogen or phosphorous loadings from

animal production in Europe, particularly the innovative studies coming out of the Netherlands

(need cites), provides a clear example of the utility, and necessity, of the mass balance approach

when a single constituent is of primary importance. Nevertheless, as Figure 3, demonstrates,

even in this case, which is particularly conducive to such an approach, a mass-balance

framework will only tell a part of the story.

33

For example, the mass-balance approach implicitly assumes that a unit of nitrogen

discharged to surface waters as organic N is equivalent to the same unit discharged in a gaseous

form. Absent estimates of social damages associated with the various discharge avenues, a

compromise approach might involve a disaggregated accounting of discharges in terms of

environmental metrics. Interestingly, though Schwabe’s calculations allow for an assessment of

the various end points for nitrogen applications, no such accounting is made. Using his example,

of the 138 pounds applied, 23.7 pounds appear to be “lost” to the system, and another 19.32

pounds are converted via a treatment process. While some portion of those losses may be inert,

e.g., stored in the soil profile, another portion likely is due to volatilization. The potential surely

exists for emissions to the “airshed” to vastly exceed the 2.9 pounds emitted to the watershed.

The previous example suggests yet another nod to the important insights and enduring

value of the original mass-balance work. At first glance, the potentially wide disparity between

water and air emissions suggests our oft-repeated concerns regarding a simple mass-calculation.

Intuition suggests that a focus on mass would lead the analyst towards a greater concern for air

emissions, if, as we suspect, they in fact are significantly larger than water emissions. However,

it bears repeating that K,A&D emphasized both the need to consider the assimilative capacity of

“problemshed” to which discharges occur and the need to simultaneously consider multiple

discharge media. The importance of considering assimilative capacity is also a central tenet of

Kneese and Bower (1968). The assimilative capacity of the airshed likely vastly exceeds the

assimilative capacity of the watershed in the Neuse River example.

As a final note, as much as in any other realm, the recent advances in computer

technology, spatially-referenced data and analytical tools, and physical and biological process

34

models have direct applicability to this problem, which is ripe for advances along this line of

inquiry.

b. Agri-Environmental Policy Analysis

USDA conservation programs – including the Conservation and Wetlands Reserve

Programs, the Environmental Quality Incentives Program, and the new Conservation Security

Program – are increasingly multi-objective in nature. Goals for these programs range from

reducing soil erosion and improving soil productivity, to improving surface, ground, and

estuarine water quality and air quality, to reducing greenhouse gas emissions and improving

wildlife habitat. A better understanding of the degree to which those goals conflict with or

complement each other will enhance our understanding of the economic and environmental

implications of alternative policy designs for implementing such multi-dimensional programs.

Inherent physical and economic heterogeneity, affecting the fate and transport of

alternative constituents, combined with vast divergences in the social costs of each (and a

general lack of biological or economic studies assessing damages across media and constituents,

suggest that a “pure” mass-balance approach is not ideal for this setting. Nevertheless, it surely

cries out for an integrated analysis. While studies exist that attempt to model externalities and

policy options for linked animal and crop production systems (e.g., Schnitkey and Miranda, other

cites), or, for example, linkages and tradeoffs between nutrient and pesticide emissions (e.g.,

Randhir and Lee, other cites), these studies tend to be narrow in geographic scope (e.g., small

watersheds) and limited in the types or numbers of externalities considered. ERS has initiated a

program of research designed to fill that gap.

35

Before describing results from ERS’ empirical analysis, we first provide a bridge back to

the A&K framework. Figure 4 is a simplified representation of figure 2, as applied to the

agriculture sector. Fertilizer is used as an input to hay crops (animal feed), and food crops, but

not to livestock production directly. Water is used as an input to hay, livestock, and food crop

production. Some of the manure from livestock production is used as an input to hay and food

crop production, and some food crops are used to supplement hay fed to livestock. Finally,

livestock and food crops, but not hay, are sold to households for final consumption. Both hay

and food crop production result in nitrogen (N) and phosphorus (P) residuals, but in different

proportions. Livestock production results in manure residuals – the excess amount not applied to

hay and food crops. While this stylized framework provides a convenient structure for

characterizing important linkages in the broad agricultural sector, as well as demonstrating an

approach to modeling constituent emissions rather than total mass while remaining within the

context of the framework. Yet, as in the animal waste problem discussed above, the mass-

balance approach, strictly applied is limited in its ability to address the issue of concern in this

problem. Nevertheless, it provides a useful departure point.

The agri-environmental example is presented here as a counter point to the animal waste

example presented above. 11 In the animal waste case, model extensions have been, and likely

will be, in the realm of more careful balancing of nutrients in the system, as well as a more

careful accounting of the upstream and downstream linkages in the system. Importantly, that

characterization requires the retention of an underlying mass balance framework. In contrast, the

agri-environmental problem discussed in this section focuses explicitly on tradeoffs among

multiple disparate environmental objectives. Thus, this example suggests a “widening” rather

11 This discussion draws heavily from Johnasson, Classen, and Peters, 2001.

36

than a “deepening” of the paths analyzed, and can be characterized more as following along the

intent, if not the “letter,” of the general equilibrium notion expressed in A&K.

For a nationwide voluntary conservation policy to addresses the menu of externalities

associated with U.S. agricultural production it is necessary to address many potential pollutants

and their relevant medium (air, water, and soil). This analysis tracks changes in nine potential

agricultural pollutants for agricultural cropland affecting four media: surface water (sheet and rill

erosion, nitrogen, phosphorus, and pesticides), ground water (nitrogen and pesticides), air (wind

erosion and carbon emissions), and soil (decreasing productivity). To facilitate the ana lysis and

exposition the United States is separated into 90 production regions. Each of these production

regions is viewed as an economic agent who seeks to maximize profits given a policy

environment in which to operate. Cropland enterprises are chosen from a set of crop rotations,

residue management strategies, and fertilizer applications. Given the 90 regions (45 non- and

highly-erodible regions) and various production management choices (tillage, rotation, and

nitrogen fertilizer rate) more than 5000 agricultural production operations are available for

simulation analysis. The environmental simulation model EPIC is used to generate crop yields

and environmental externalities on a per acre basis for short-run production (7 years) and for

long-run production (67 years) given historical climate and soils data from across the United

States. The yield and externality data are combined and calibrated to current production patterns.

USMP is then used to estimate the optimal production shifts accounting for price changes

resulting from policy shocks. An aggregate benefits score can then be generated for each USMP

production enterprise. This aggregate benefits score is composed of the "relative damage

estimate" (RDE) for each of the environmental externalities being considered, based on the mass

of each pollutant that arrives at the appropriate medium for each conservation practice.

37

The respective RDEs are the product of edge-of- field emissions and the corresponding

transport factors:

kjkjikji tqRDE *= (9)

where q are edge-of-field emissions, t is the relevant transport factor, k indexes the region, j

indexes the environmental externality, and i indexes the production system (Table 3).

Transport factors are estimated from predicted agricultural emissions in the case of

surface water pollutants and are assumed to be 100% for soil, air, and ground water media (i.e.,

there is no assumed loss in mass from the edge-of-field emissions to the relevant destination

media). The resulting relative damage estimates are a measure of the pollutant mass reaching the

relevant environmental medium (Table 4). Negative values for soil productivity indicates that

most available farming practices actually increase soil productivity over time. Similarly,

negative carbon emission values indicate practices that sequester more carbon than baseline

pasture coverage. Production systems having low relative damage estimates (RDEs) indicate

cleaner practices; conversely those with high RDEs are those contributing higher quantities of

pollutants to the environment.

A weighted sum of the individual environmental indicators provides an aggregate

environmental quality index:

∑=j

kjikjki IwI (10)

where kjw are weights on pollutant damages. This functional form implies that damages to the

environment are continuous and linear in emissions. This is similar to other aggregate measures

of environmental quality such as the Environmental Benefits Index (FSA, 2002) and the Index of

38

Watershed Indicators (USEPA, 2002).12 Ideally the weights chosen would reflect socio-

economic preferences for mitigating the various pollutants (Heimlich, 1994). For the purposes of

this analysis we simply let all weights equal one, which essentially serves to focus only on the

physical mass of each externality arriving at the respective medium.

Two policies options are considered — one that provides payments for improving farm

environmental performance, and another that provides payments for the use (whether on-going

or new adoption) of practices that are generally environmentally preferred, e.g., BMPs). Despite

generating approximately the same effect on the aggregate environment, the two policies yield

different results for changes in individual amounts (Table 5). Under the more flexible

performance-based policy, a greater percentage of environmental benefits are achieved by

reducing the amount of nitrogen to ground water and pesticide discharges. The less flexible

practice-based generates a greater percentage of benefits via increasing soil productivity and

reducing wind erosion.

Obviously these results are a function of many complex policy and environmental

parameters. It may be possible to simplify the policy approach by focusing on a more narrow set

of pollutants. If certain externalities were highly correlated it might be feasible to remove them

from the aggregate environmental index without loss in environmental cost-effectiveness. One

way to identify key variables in a reduced form for the environmental quality index is to examine

the correlation matrix of the nine pollutants. This matrix indicates the correlation between the

externalities across all possible management choices (Table 6). For example, changes in

management practices resulting in reduced levels of sheet and rill erosion (Sheet) are associated

with increased nitrogen loading to groundwater (Nitr_G), when weighted by the respective RDEs

12 The assumptions of continuous and linear damages serve to illustrate the costs to producers in reducing the physical amounts of these pollutants from entering the environment. More complicated damage functions can be

39

for these two pollutants. Abatement of all the pollutants is obviously related to positive

movement in aggregate environmental quality (Sum). In addition it appears that phosphorus

abatement has the largest positive correlation nationally with environmental quality and soil

productivity the least. There are very few externalities that are highly correlated with each other,

excluding that between soil erosion and phosphorus. However, phosphorus discharge to surface

water is positively correlated with all pollutants with the exception of wind erosion.

Summary. Despite the caveat that the weights to place on the externalities and the correct

functional form to choose for aggregate environmental quality are essential for such analyses,

there are some general conclusions to be drawn from these policy simulations. First is that agri-

environmental payments for the provision of broadly defined environmental benefits requires a

measure of aggregate environmental quality, without which measuring the effects of such

policies is impossible. It is also possible to simplify analysis by identifying the key pollutant or

pollutants by region that have the greatest effect on aggregate environmental quality and that are

posit ively correlated with the majority of the other variables. Nationally it appears that

phosphorus discharge to surface waters is most highly correlated with environmental quality (as

defined above). However, when this effect is examined at smaller scales, such as farm

production regions the externality having the highest correlation with environmental quality is

less clear.

IV. Summary and Conclusions

This paper explores the historical roots of current and future innovations in the residuals

management literature, with an eye toward linkages to RFF’s innovative research program in this

incorporated into future analysis by changing the form of the aggregate environmental indicator.

40

area. It involves a journey of sorts, backwards and forward “through the looking glass,” into the

materials balance framework developed by Ayres and Kneese and Kneese, Ayres and d’Arge.

Those products yielded something of a paradox. They represent seminal pieces of research by

nearly all reasonable standards, except that they aren’t particularly well known. In some ways

the research transcends itself. One of the key insights arising from that work is that externalities

are pervasive. Yet that pervasiveness, in concept, if not in its literal extreme, is taken for granted

by the current generation of environmental economists.

A second key insight is that, as a logical consequence of the princip le of conservation of

mass, externalities are inherent in all production and consumption activities, suggesting a

divergence between social and private prices for all goods. The policy implications of that

perspective are rather extreme, suggesting an economy-wide set of corrective prices. Less

extreme, but still onerous form an empirical perspective, is the notion that policy analysis or

external diseconomies requires a general equilibrium modeling framework. Importantly,

however, this perspective suggests a counter- factual; the smaller are the indirect production

effects and the weaker are the linkages among materials and pathways, the closer will the partial

equilibrium analysis approxmiate the social optima. We develop a highly simplified numerical

example to demonstrate the types of relationships one might explore to do a preliminary

assessment of the relative costs (in terms of efficiency losses) and benefits (in terms of foregone

research time effort, and data requirements) of abstracting from the strict application of a mass-

balance/general equilibrium.

We return to the stylized example throughout the paper both as a means of providing

transparency to the rather dense model presented by Kneese, Ayres, and d’Arge, and as a check

for apparent consistencies and inconsistencies with the problem at hand. In the end, we find that

41

in some cases we have barely scratched the surface in terms of the potential advances suggested

by Kneese and his colleagues. In others we have “reinvented the wheel,” following along the

path laid or at least hinted at by RFF researchers, without realizing it.

Without a doubt Kneese developed a visionary program that in some cases our analytical

tools and perspectives are just catching up to, 30 years later! One clear example was the

admonition that efficiency in externality control demands a multi-media analytical framework.

Despite obvious tradeoffs between air pollution and water pollution, for example, in the

management of animal wastes, we, as a profession, generally persist in single media analysis.

The implicit (and explicit in the case of the Delaware ecosystem analysis) call for

interdisciplinary, integrated analysis is increasingly being answered, in part pushed by funding

agencies, and in part pulled by new academic departments and the relatively recent proliferation

of interdisciplinary journals, as well as new technological and conceptual analytical tools and

capabilities. In any case, the possibilities are endless and we have a sneaking suspicion that the

full influence of Kneese’s original research program has yet to be realized.

42

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Figure 1: Citation History for Ayers and Kneese and Kneese, Ayers, and d’Arge, and selected

contemporaneous academic and institutional/regulatory events.

Institutional Events:

51

X1

r1

r2

"THE ENVIRONMENT"

Rawmaterials

Intermediatecommodities

Finalproducts

"THE ECONOMY"

X2

a11X1

a12X2

a13X3

a21X1

a22X2

a23X3

C12X2

C13X3

C21X1

C23X3

C31X1

C32X2

Y1

Y2

Y3X3

E1 E2 E3

Figure 2: Stylized Schematic of Ayres and Kneese and Kneese, Ayers, and

d’Arge’s mass-balance framework, incorporating disposal to the environment.

52

Table 1:

j = 1 2 3

1

1

EY

YE J

j∂∂

0.597 0.263 0.143

2

2

EY

YE J

j∂∂

0.317 0.518 0.173

3

3

EY

YE J

j∂∂

0.359 0.317 0.317

53

Table 2: General Equilibrium Analysis Results The socially optimal levels of Y and r are: j Y*(j) E*(j) r*(j) - -------- -------- -------- 1 0.014885 0.19666 0.42816 2 0.012176 0.17600 0.24317 3 0.010703 0.26091 The free market levels of Y and r, and their associated prices, are: j Yeq(j) peq(j) Eeq(j) req(j) veq(j) - ------ ------ ------ ------ ------ 1 0.015385 1.00000 0.20568 0.44932 0.05588 2 0.013150 1.16990 0.18592 0.25492 0.08262 3 0.011073 1.38935 0.27303 Prices required to induce Y* and r* are: j peq+ty(j) veq-tr(j) - --------- --------- 1 1.00000 0.05228 2 1.22250 0.07902 3 1.39074 So the required taxes are: j ty(j) tr(j) - ----- ----- 1 0.00000 0.00360 2 0.05260 0.00360 3 0.00139 Given a tax on Y1 to induce Y1*, call it t1, the equilibrium levels of Y and r, and their associated prices, are: j Y|t1(j) p|t1(j) E|t1(j) r|t1(j) v|t1(j) - ------ ------ ------ ------ ------ 1 0.014885 1.00000 0.20276 0.44600 0.02901 2 0.013216 1.12630 0.18520 0.25280 0.12658 3 0.011118 1.33891 0.27162 Given a tax on Y2 to induce Y2*, call it t2, the equilibrium levels of Y and r, and their associated prices, are: j Y|t2(j) p|t2(j) E|t2(j) r|t2(j) v|t2(j) - ------ ------ ------ ------ ------ 1 0.015539 1.00000 0.20309 0.44082 0.12261 2 0.012176 1.27619 0.18002 0.25062 -0.02681 3 0.011185 1.38935 0.26942 Given a tax on Y3 to induce Y3*, call it t3, the equilibrium levels of Y and r, and their associated prices, are: j Y|t3(j) p|t3(j) E|t3(j) r|t3(j) v|t3(j) - ------ ------ ------ ------ ------ 1 0.015446 1.00000 0.20485 0.44567 0.05551 2 0.013216 1.16874 0.18486 0.25284 0.08316 3 0.010703 1.44313 0.26944

54

Animal Production

CropProduction

Animal WasteManagement

N in animal products

N organicfertilizer

N volatilization(NH3, NO, N2O, N2)

N deposition(ammonia, etc.)

Inorganic Nfertilizer

N leaching to groundwater

(NO3)

N volatilization(NH3, NO, N 2O, N2, amines, pyridines,

others)

N in feed

Recycled NRecycled N

N volatilization(NH3, NO, N2O, N2, amines, pyridines,

others)

N runoff to surface water

(NO3, Organic N)

Other sources of N

N loses from transportation

and application

N in crops

Figure 3: Mass balance for nitrogen associated with animal production.

55

hay

fertilizer

water

"THE ENVIRONMENT"

Rawmaterials

Intermediatecommodities

Finalproducts

"THE AG SECTOR"

livestock

a11X1

a13X3

a21X1

a22X2

a23X3

C12X2

C21X1

C23X3

C32X2

Y2

Y3food crops

2 parts N,1 part P

Manure 1 part N,2 parts P

Figure 4: Stylized Schematic of Ayres and Kneese and Kneese, Ayers, and d’Arge’s mass-balance framework, as applied to the agricultural sector.

56

Table 3: Relative Damage Estimates

Relative Damage Estimate (acre -1year-1) Environmental Externality

Medium Units Transport Factor

Sheet and Rill Erosion Surface Water Tons Same As Phosphorus Nitrogen Estuary Lbs. Derived from SPARROW1

Phosphorus Surface Water Lbs. Derived from SPARROW Pesticides Surface Water TPUs1 Same as Phosphorus Nitrogen Ground Water Lbs. 100% Pesticides Ground Water TPUs 100%

Wind Erosion Air Tons 100% Carbon Emissions 1 Air Metric Tons 100%

Loss in Soil Productivity Soil $’s 100%

57

Table 4: Descriptive Statistics

RDE Mean Min Max Max - Min

Sheet and Rill Erosion 0.206 0.000 7.238 7.238 Nitrogen to Estuaries 0.164 0.000 4.350 4.350

Phosphorus to Surface Water 0.136 0.000 1.404 1.404 Pesticides to Surface Water 256.400 0.000 62,154.494 62,154.494 Nitrogen to Ground Water 5.694 0.000 65.828 65.828 Pesticides to Ground Water 189.405 0.000 6,638.688 6,638.688

Wind Erosion 3.968 0.000 749.651 749.651 Carbon Emissions 0.344 -0.509 0.687 1.195

Loss in Soil Productivity -0.421 -64.421 46.886 111.306

58

Table 5. Composition of Environmental Benefits (7 Million Benefit Points)

Practice-Based Performance-Based Annual Externality Base

Abatement Abatement Nitrogen Estuary (38.89 lbs.) 1.79 4.59 % 1.73 4.44 % Nitrogen Ground (1,706.03 lbs.) 18.46 1.08 % 31.73 1.86 % Phosphorus (44.22 lbs.) 2.46 5.57 % 2.35 5.32 % Sheet and Rill Erosion (47.63 tons) 2.43 5.09 % 2.19 4.59 % Wind Erosion (717.59 tons) 57.13 7.96 % 9.74 1.36 % Loss in Soil Productivity ($372.35) 274.80 73.80 % 156.10 41.92 % Carbon Emissions (114.19 metric tonnes) 1.02 0.90 % 0.98 0.86 % Pesticides Surface (140,625.26 TPUs) 296.85 0.21 % 559.87 0.40 % Pesticide Ground (36,321.81 TPUs) 324.65 0.89 % 700.41 1.93 %

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Table 6. Environmental Correlation Matrix*

Correlation Sheet Nitr_G Nitr_E Phos Prod Carbon Wind Pest_S Pest_G Sum

Sheet 1.00 Nitr_G -0.04 1.00 Nitr_E 0.32 0.08 1.00 Phos 0.56 0.21 0.35 1.00 Prod 0.01 -0.10 0.04 0.04 1.00

Carbon 0.17 -0.01 0.05 0.12 -0.20 1.00 Wind 0.17 -0.06 -0.04 -0.03 -0.04 0.09 1.00

Pest_S 0.10 -0.02 0.01 0.14 -0.03 -0.06 0.03 1.00 Pest_G -0.02 0.31 0.04 0.15 -0.03 -0.14 -0.04 0.04 1.00

Sum 0.55 0.55 0.54 0.72 0.11 0.35 0.14 0.12 0.38 1.00 * Sheet = sheet and rill erosion, Nitr_G = nitrogen discharge to ground water, Nitr_E = nitrogen discharge to estuaries, Phos = phosphorus discharge to surface water, Prod = loss in soil productivity, Carbon = carbon emissions, Wind = wind erosion, Pest_S = pesticide discharge to surface waters, Pest_G = pesticide discharge to ground water, Sum = aggregate environmental index (equation 3).

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