omar-towards a sustainable...

Towards a Sustainable Economy

By Omar AlrasbiSOS 513 Science for SustainabilityProfessor Jianguo Wu

Contents

´ Introduction´ Theories of Economic Growth´ Source and Sink Constraints in the Economy´ Economic Growth and Sustainable Development´ Discussion´ Summary

Introduction

´ The industrialization process.

´ The postindustrial transition process.

An Archetypical mode

´ The affluent countries are in the later stages of the transition.

´ In the low-income countries are in the early stages of the transition.

´ An influence diagram of the archetypical transition process in an isolated economy

Limitations of the Archetypical model

´ It presumes that countries can maintain economic growth rates and thus, implicitly, can overcome a number of social, resource and environmental constraints.

´ The real-world transition can differ from the simulated one for at least two specific reasons. First, the IU and EKC hypotheses have limited validity. ´ The IU hypothesis presupposes the existence of a substitute, such as

plastic from oil for steel, that is itself part of another chain with similar dynamics.

´ The EKC hypothesis may be invalid or too late for indirect and long-term impacts, because citizens do not experience the negative consequences themselves.

Limitations of the Archetypical model Cont’

´ No country operates on its own (Globalization). Historically, resource shortages have been countered by military conquest, import of resources and outmigration of people.

´ Nowadays, trade is the preferred choice and mineral ore and fossil fuel are the largest bulk trade flows in the world.

´ Availability on the world market will come under stress and cause political tensions and fluctuating prices. A counterforce is that resource extraction costs, at least temporarily, decrease because of innovations, but this will partly be undone by oligopolistic price setting and safety and environmental regulations .

´ Real-world resource prices can also be expected to fluctuate significantly, which in combination with mismatches between demand and supply from system delays, feedbacks and noise effect the overall process. History abounds with examples.

Substitutability, Technology and Optimality

´ An industrial economy can make the transition to a sustainable state, provided the average income stabilizes and there are sufficient resources, substitutes and sinks.

´ During the transition, price-based market forces, government-coordinated regulatory policies and behavioral changes are all three needed. Even then, there will be periods during which parts of the population suffer from negative environmental and social impacts.

´ The experiences in the United States and Europe show that part of the damage is reversible and can be undone. Pollution-related diseases can be addressed with medical expenses and technology; rivers and soils can be cleaned up or will slowly recover if no longer under stress.

Substitutability, Technology and Optimality Cont’

´ Some impacts are irreversible, notably the expected change in climate and the loss of biodiversity.

´ The social impacts show up as a further increase in income and wealth inequality, decline of community life and tensions in the provision of public goods.

´ These can be remedied by proper social security schemes and public planning, but here the experience shows that it is difficult in times of high expectations, rapid globalization and large uncertainties.

Substitutability, Technology and Optimality Cont’

´ The assumptions of resource substitutability and of technological change are the critical ones in macroeconomic analyses of growth and sustainability.

´ Per capita consumption can continue to grow until the investments needed to compensate the declining resource quality become so large that the output available for consumption makes further net growth impossible. Beyond that point, per capita utility inevitably declines.

´ If environmental constraints are also considered, the long-term feasibility of sustainable pathways is further narrowed down. Such source and sink constraints, notably in mining efficiency, land yields and pollutant elimination, are the causes of collapse in the Limits to Growth model (Meadows et al. 1971)

Solutions provided by the Substitutability approach

´ First solution is the existence of a backstop resource, which is a substitute resource that is available in nearly infinite amounts.

´ A second solution is technology that makes it possible to perform economic activities at vanishing resource and environmental intensity, as is the case in extreme forms of the IU and EKC hypotheses.

´ A third and officially rarely discussed possibility is a change in lifestyle and values that breaks by a mixture of necessity and creativity, the link between the use of finite sources and sinks and the quality of life.

´ For many people, this is what the sustainability transition is about. It is implied in Stuart Mill's famous statement: ‘I sincerely hope, for the sake of posterity, that the population will be content to be stationary, long before necessity compels them to it’. It would coincide with a less materialist worldview.

Economic Optimality

´ Macroeconomists have explored the conditions for sustained economic growth with finite resources primarily in the form of an optimal control problem.

´ The idea is to maximize the discounted utility over the time horizon considered under two constraints:´ First, the macroeconomic production function discussed later.

´ Second, the finiteness of one or more sources and sinks

Economic Optimality´ Complete source substitution cannot be excluded. It would be an

economy with complete recycling and an energy supply based wholly on a resource that can be produced in near infinite amounts at constant cost. Solar power is probably the only option that qualifies as such a backstop resource.

´ Complete sink substitution is more difficult to imagine. If sustainability is defined as the situation in which production- and consumption-related waste flows ending up in environmental sinks do not exceed the rate at which they are absorbed and broken down, then weak sustainability implies that ever larger waste flows must be treated and eliminated. One only has to consider the exergy, energy balance of the Earth to realize that this will pose limits to growth at some point in time and place.

´ Strong sustainability is more realistic to attain, which implies limited substitutability between natural and man-made capital. Long-term concerns about climate change, biodiversity and other issues in relation to economic prosperity becomes then a matter of small risks and large irreversible damage – a world far away from deterministic optimality

Theories of Economic Growth

´ Classical theories

´ Economic Growth Theory

´ The role of Technology, Learning and Behavior

The Classical Theories

´ Mainly originated by British and US Scholars. It explained how increasing trade and market size leads to specialization, which causes labor productivity to increase.

´ This in turn increases income per capita and, subsequently, market size. This positive feedback loop only starts to operate when market size exceeds a certain threshold.

´ The early political and ethical works of classical economic theory are gradually narrowed to a body of highly abstract and rather esoteric concepts and hypotheses.

´ One explanation for this is the desire, in the context of the Modernist worldview, to become an objective ‘natural’ science.

The Classical Theories

´ Modern economic (growth) theory has a narrow perspective and is largely associated with (Anglo-American) capitalism. Ethical issues such as a fair reward distribution between the production factors, capital, labor and, later, between the rich and the poor and between present and future generations were formalized and rationalized or disappeared altogether from mainstream economic literature.

´ Social scientists, including many political and welfare economists, are critical of this development and its consequences and of the validity of the underlying ‘image of man’.

Economic Growth Theory


´ The basic equation of the neoclassical growth model. Where:´ k is capital per worker K/L

´ m depreciation at a fixed rate

´ n growth of labor force

´ c consumption


´ From a sustainable development perspective, the neoclassical growth model suggests the best of possible worlds and a recipe for sustainable development. It predicts that per capita income levels can exceed subsistence levels permanently through capital accumulation, that is, rising k, in contrast to Malthus’ conviction. It indicates that an economy has a natural tendency to reach a zero-growth steady-state and that per capita income differences between countries have a natural tendency to disappear.

´ Unfortunately, even apart from resource and environment constraints, the real world behaves differently. Capital accumulation and capital-labor substitution undoubtedly played an important role in economic growth. But time-series and cross-country analyses of economic growth in industrial economies during the 20th century show that they explain only half or less of the observed output growth and that no income convergence amongst the countries of the world takes place except in a few ‘convergence clubs’.

Economic Growth Theory Cont’

´ Reason of failure of the theory is the high aggregation level of description, interpretation and measurement of the production factors. Labor reflects a wide variety in skill and age levels. In advanced economies, fossil fuel is almost completely substituting for physical labor and most labor is involved in control and information.

´ Economists have introduced the notion of human capital in order to incorporate the differences and changes in skill levels with proxies, such as number of years of schooling. It provides some additional explanation (Helpman 2004). Capital also represents a variety of items and undergoes quantitative and qualitative change.

´ Capital also represents a variety of items and undergoes quantitative and qualitative change. The next table shows data for the capital stocks in four countries as quantified in monetary units by the national statistical offices. Per person capital stocks have roughly linearly increased over the last decades in these countries.

´ The first and simplest way to include technology in the production function is with an exogenous factor:

´ The term A is called the total factor productivity (TFP) and can explain a large part of productivity growth. Technology becomes an all-explaining deus ex machine. One way to estimate A is through the idea of learning-by-doing, that expresses A explicitly as a function g of accumulated knowledge by workers.

The Role of Technology, Learning and Behavior

The Role of Technology, Learning and Behavior Cont’

´ Evolutionary economists attempt to simulate two major groups of actors in an economy: producers and consumers.

´ A small group of agents (producers and consumers) ‘drive’ the system to more and novel products for consumption, exploiting the desire for profit, status and novelty.

´ Technological change is incorporated in the investment decisions of the producers. If it is completely absent, the model economy is in a steady-state with zero growth. When it is turned on, the model economy starts to evolve in a permanent disequilibrium.

´ System dynamic models of economic growth address some of the shortcomings in economic theory by introducing agents (mechanisms) that have local information about profitable opportunities for change but proceed, in the absence of global information about the (future) system, incrementally in a direction that improves the profit or another target or performance indicator.

´ Change happens in incremental steps, in a gradient-following process. The engine of economic growth is conceived of a series of connected feedbacks, or increasing returns in economist terminology. Important ones at the level of corporations are:´ Unit production cost: there is continuous drive to lower unit cost through R& D.

Traditionally, the ways to reduce costs are through economies of scale, economies of scope and learning-by-doing. All three can work as positive feedback loops through which unit cost declines.

´ Unit development cost: in many modern knowledge-intensive industries, the upfront development costs, are a large fraction of total cost and the actual production cost are small or negligible (chips, software or music as examples). Once underway, there is an enormous drive to create large sales to recover the upfront cost.

´ Product awareness: firms will use advertising and sales efforts to promote their products. In combination with word of mouth and media attention, this may create a positive feedback towards ever larger sales and market share.

The Role of Technology, Learning and Behavior Cont’

Source and Sink Constraints in the Economy

Structural Economics: The Input-Output Formalism

´ A large part of the cost of economic goods and services consists of rewards for the production factors labor L (wages or salaries)* and capital K (dividends or rent), together making up the value added (VA). Labor – in essence, organization and knowledge because most physical work has been substituted for by fuels and electricity – is usually the largest cost component. Capital, in the form of buildings, machinery and equipment, is an important second component.

´ National economic models distinguish economic sectors, each with their production function. Each sector delivers part of its output directly to consumers, including government and investments. This is called final demand. The remainder is delivered to other sectors and are called intermediate deliveries. Together with the primary inputs labor and capital, they make up the input-output (I-O) table.

Rebound Effect

´ One interesting feedback phenomenon is called the rebound effect. It is simply explained. If cost-effective measures to reduce energy and material use in industrial production help to lower production cost, they will also in the longer run reduce the product price, if competition is working. This in turn probably leads to a higher demand for the product and hence to production expansion and a higher overall material-energy use. As a consequence, a part of the benefits of the measure (material-energy saving) are annihilated by growth.

´ A similar mechanism occurs in private households when money not spent on fuel because of better insulation or lower room temperature is spent in other ways, thereby leading to additional activity and hence additional use of energy.

Resource Efficiency and Pollution Abatement: Economic Mechanism

´ The dynamics behind the changes in material and energy intensity is an important topic in industrial economics/ ecology and also in sustainability science.

´ Most goods and services are produced with a variety of inputs and consist also of many different ‘products’.

´ Engineers prefer to construct production functions on the basis of physical flows (engineering production functions), but this is only possible for a few basic processes (steel, cement and some others).

´ Currently, complex manufacturing processes are investigated in dedicated technology assessments. Monetary analyses in production economics offer nevertheless some useful insights in the mechanisms of resource efficiency, or resource saving as it is popularly called, and provide some guidelines for a sustainable resource use policy.


´ The potential to reduce the resource intensity of a process is a moving target. It depends on the changes in factor prices and on the progress made in technology and organization. Moreover, other product and process innovations and marketing dominate business decisions, because in most firms the costs of energy and materials are only one, often minor, element in a dynamic and competitive environment of capital and labor related decisions.

´ Large fraction of office managers and households still have only limited knowledge of energy/ material costs and, if so, see them in relation to their income – and conclude, for instance, that a tough negotiation about wages brings in more money than investing in resource efficiency. Finally, there is the rebound effect. These barriers to sustainable resource use have to be overcome by better information and indicators and by gradual changes in perceptions and behavior.


´ Other obstacles to realizing the economic potential are status-driven behavior, incomplete information on prices and available techniques, and diverging values, for instance, between cultures. It can also work in the other direction, as with status, and if one includes the positive externalities such as lower emissions and other co-benefits, there may exist even negative cost options.

´ The preceding formalism can also be applied to pollution abatement. Investment decisions are made in order to replace part of operational costs for waste management and emission charges by fixed capital costs. Those operational costs now concern non-market priced environmental goods such as clean air or water, and society must agree on some price, via taxes or emission trading, or introduce and enforce regulation and standards in order to elicit the necessary investments

Economic Growth and Sustainable Development

GDP and the Need for a Better Indicator

´ The usual measure for the standard of living is the gross domestic product per person. In combination with the expectations and aspirations of people, heightened in today's globalizing world of communication and advertisements, there is an enormous momentum for ongoing economic growth of GDP.

´ Such growth is hoped to satisfy the large still unmet basic needs of the population in low-income regions and provide jobs in order to distribute rising welfare and prevent social unrest. It is also driven by the desires of an emerging middle class for the luxuries of modern life. In the high-income countries, only a combination of steady innovations, advertisements and high levels of working hours can bring ongoing growth in GDP and income.

GDP and the Need for a Better Indicator

´ In the calculation of GDP, there is no distinction made between costs and benefits. This may cause a serious overestimation of GDP as a source of quality of life. Many market-related transactions contribute to GDP but are not benefitting anyone and are actually costs (negative externalities). Well-known examples are the expenditures associated with traffic accidents, pollution abatement and natural disasters

´ There is no distinction between stocks and flows. Resource use is accounted for in GDP on the basis of the monetary value of the extraction flow, without accounting for the decrease of the resource stock. It is like counting only the money you withdraw from your account, without considering the debt you are building up meanwhile.

´ Similarly, the degradation of environmental sinks is not counted in GDP, whereas it incurs future costs in order to maintain quality of life that are counted in future GDP. Thus, many negative externalities are either counted as positive contributions or not counted at all or are counted showing up as ‘contributions’ to future GDP.

Alternatives to GDP´ Sustainable Economic Welfare (ISEW), which tries to account for

contributions to GDP that are actually costs. It has been constructed for many countries. Using a set of conventions and assumptions, well-being measured as ISEW stopped growing in most countries some decades ago.

´ The second indicator is the genuine savings rate, which focusses primarily on the adequate inclusion of changes in natural and human capital. This one has also been constructed for many countries.

´ The results suggest that GDP growth is significantly overestimated in countries that overexploit their oil and forest resources, whereas it is underestimated in those that have invested in education. I refer to the Useful Websites for more details. Interestingly, there are also reasons to suspect that GDP and income underestimate our well-being, or at least welfare and utility.

Beyond Models: Welcome in the Real World

´ Elementary models of economic growth, it seems, make up a consolidated body of theory, closely connected to prevailing attitudes and practices, and there is as yet no coherent alternative.

´ There are numerous shortcomings and criticisms of mainstream economic theory). This is not surprising because the (world) economic system is extremely complex and strong knowledge about it is not to be expected.

´ The inadequacy of economic theory is partly because of an overemphasis on mathematical formalism: ‘The human mind is built to think in terms of narratives, of sequences of events with an internal logic and dynamic that appear as a unified whole.

Towards a sustainable Economy

´ The struggle for resources. Rising demand in combination with scarcity and environmental change lead to price volatility and speculation, which in turn trigger social unrest. It induces corruption and war in states with large resources but weak governance and institutions. World price and trade agreements for specific commodities are part of the solution. Transfer of technologies and introduction of standards and labels for more efficient resource use and recycling are another part.

´ The income and wealth gap. A conventional view on economic inequality is that wealth ‘trickles down’ from the richer to the poorer strata of society with a rise in average income. ‘A rising tide lifts all boats.’ This view rationalizes wealthy people's desire for more. But the measured effects of growth on the poorest segments of society are controversial. Often, a more appropriate aphorism is ‘the winner takes it all’. The erosion of middle classes and taxpayer ethics is a matter of concern in this respect. There is probably an ‘optimum’ income inequality, when the incentive to take risks and create wealth is in balance with the fairness needed for citizen's compliance. . Outside such a balance, social and economic stability is at risk. Restoration of government legitimacy and other forms of redistribution than through paid jobs and taxes are needed.

Towards a sustainable Economy Cont’

´ Trade and globalization. More open economies are said to have higher economic growth rates. But trade effects are mixed up with trends in transport cost, capital mobility and credit and debt formation. In theory, trade can encourage or discourage the growth of income per capita. In practice, the already rich countries appear to benefit most. There is a need for whole-chain analyses in order to understand and evaluate the effects of trade on local, regional and global sustainability. Globalization is perhaps already in the overshoot domain and targeted forms of protectionism are needed.

´ Corporate responsibility. In the absence of legitimate global governance, sustainable management of the ‘global commons’ cannot succeed. The short-term and quick and high returns still dominate most business. Design and implementation of more stringent rules for corporations, as laid out in, for instance, Corporate Social Responsibility (CSR) and Earth Charter, are needed and some corporations already take the lead. The financial system in particular has to be transformed towards more responsible behavior.

Towards a sustainable Economy Cont’

´ Internalize, encouraged by regulation and prices, an ethic that does not permit shifting the burden onto people far away in space and time and onto other species

´ As part of internalizing, redirect consumerist lifestyles towards more immaterial lifestyles that emphasize moderation, intelligence, cooperation and sharing.

´ Follow basic principles of ecology: there is no such thing as ‘waste’ in nature, interdependence is the rule not the exception. Biodiversity is the best insurance for adaptiveness and spread of risk and there is only one energy source: the sun.

´ Redirect technical innovations towards a better balance between rich consumer wants and poor human needs and stimulate a ‘green economy’ of reuse, recycling and renewables

´ Apply the subsidiarity principle: global governance where necessary and local governance where possible, in order to give room to the greatly needed dynamic and creative forces of civic communities and entrepreneurial capitalism;

Discussion´ G3. Is the current state of Economy in the affluent nations leaning

towards being sustainable?´ If your answer is yes then provide signs of it’s sustainable state.´ If your answer is no then suggest the vital steps to transition to a

sustainable state

´ G2. Is capitalism lenient or socialistic lenient structure the path to sustainable economy? Why?

´ G1. In what positive or negative aspects does globalization affect sustainable economoy?

Summary

´ Neoclassical models of economic growth focus on the role of capital, labor and technology (capital-labor ratio's, substitution, income convergence, steady-state). The models are founded on oversimplified ideas about the physical and the social world and are poorly reproducing the empirical data on economic growth.

´ Technology and innovation dynamics, human behavior and subsystems such as the financial system, government policies and the informal economy must be incorporated in the models to make them useful for sustainable development strategies and policies. Complex system science will advance such efforts.

´ Empirical input-output (I-O) tables and treatment of resource efficiency and pollution abatement as capital-resource substitution are useful approaches in assessing overall system effects and resource and environment aspects of economic activities and growth.

Summary Cont’

´ We do need a more adequate indicator than GDP in order to measure well-being and quality of life and to formulate targets and evaluate progress towards sustainable development. Some promising efforts are underway.

´ Experimenting with novel arrangements and models of economic activity to redress perverse incentives for and addiction to material growth and to organize more fair redistributions of what the Earth can sustainably produce are amongst the great challenges for the 21st century. A proper balance between global governance and local creativity and community is a crucial ingredient.

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