Friday, July 31, 2009

An Even Sterner Review

A nice paper by Sterner and Persson points out that analyses like the Stern Review do not take into account the possibility that the prices of environmental goods will rise relative to those of anthropogenic goods and services as they become scarcer. They replace the standard utility function in Nordhaus' DICE model (which assumes infinite substitutability in consumption between environmental and non-environmental goods) with a function that assumes that the elasticity of substitution in consumption between environmental and consumption goods is 0.5. The lower the elasticity of substitution is the steeper the relative price rise will be for a given increase in scarcity. They find that using Nordhaus' high 3% rate of pure time preference results in optimal emissions falling below those based on the Stern Review assumptions by 2080:

and falling to zero before the end of the century.

I've long thought that limits to substitutability in consumption between environmental and non-environmental goods are important. Philibert's article in the ISEE Encyclopedia makes the point that the rising relative price of environmental assets might well negate the effect of discounting on the value of future environmental damages. This paper was on the reading list for my environmental economics course at RPI because the concept didn't seem to be covered elsewhere. The rising value of environmental assets over the course of economic growth was first raised it seems by John Krutilla in his famous paper "Conservation Reconsidered".

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