182 – Increasing marginal costs of environmental projects
One of the key insights of economics is the idea of increasing marginal costs – as you produce more and more of a good, production usually gets more expensive per unit. This idea usually relates to manufactured goods but is highly relevant to environmental ‘goods’ as well. It has implications for environmental management that often seem to go unrecognised.
Increasing marginal costs is one of the most fundamental ideas in economics. It is the first thing you learn about when studying the economics of production. To force more output out of a given production process, you may have to pay workers more in overtime, or pay more for inputs, or use a more expensive production system, or reduce production of something else that was making you money, so the cost of production goes up.
Evidence for this is everywhere, if you look. For example, consider the fact that, when the price of wheat goes up, farmers around the world quickly increase their production of wheat. This reflects that farmers need a higher wheat price to cover the higher costs of more production. (In the long run, there can sometimes be economies of scale, which go the other way, but that’s another story.)
For some years, a lot of my research has focused on environmental issues related to land use and land management. For issues like biodiversity protection, dryland salinity, soil erosion and nutrient pollution in waterways, the key to improving environmental outcomes is often to change land use or land management.
You could, if you had economic tendencies, think about this as a process of producing or “supplying” environmental goods. The goods are more biodiversity or less-polluted rivers, and the production process consists of changing land use or land management. The more you change, the more environmental goods you produce.
Should one expect increasing marginal costs in this environmental “production” process? Absolutely.
If only very small changes were required, you could cherry pick the cheapest options for change. By picking the cheapest options, you could achieve the greatest environmental improvement that was possible within the environmental budget. As you move to steadily larger targets for change, you aren’t able to be so choosey any more, and are forced into steadily more expensive changes.
For example, if the key response to an environmental issue is conversion of crops to native vegetation, you’d tend to start with those areas where crop production was least profitable (where the “opportunity cost” was lowest). As the required changes increased in extent or intensity, you would have to convert steadily more-profitable crop land, so that, at the margin, the cost of providing greater environmental benefits would increase. The same sort of thing would apply if the changes required were reductions in fertilizer use, or changes in grazing management. In order to maximise environmental outcomes, you’d start with the cheapest options and work up.
Figure 1 is a real example. It is taken from a study we did calculating the cost of achieving different reductions in flows of phosphorus into the Gippsland Lakes in Victoria. Because more ambitious targets for nutrient reductions require us to take up less and less attractive management options, the total cost goes up at an increasing rate. It’s actually quite cheap to reduce nutrients by 10%, but its very expensive to reduce them by 40% – much more than four times as much.
Figure 1.
Now, in the world of land and water conservation, an idea that has a lot of currency is that of seeking “landscape-scale” change. The hope is that, by fixing up environmental problems across the whole landscape, you’ll generate benefits that are more than the sum of the parts. It is assumed that by fixing the whole landscape, you can get exceptional aggregate benefits, even if the benefits from fixing up parts of the catchment would be modest.
That may or may not be true in particular cases (see PD183), but either way, it is not just benefits that matter. Especially when considering management of large areas, it is highly likely that making changes across the whole landscape will result in exceptional aggregate costs. For landscape-scale interventions to be better than more targeted interventions, the escalation of benefits as the area treated increases would have to be greater than the escalation of costs. Whether that’s the case would need to be assessed on a case-by-case basis.
Thus, even if one is confident that there will be exceptional aggregate benefits from a landscape-scale response, one shouldn’t just assume that this is the way to go without considering the cost side of the equation. When the environmental budget is limited (and it always is), it may be that the greatest environmental benefits in aggregate can be achieved through a larger number of more modest-scale projects, rather than a small number of huge projects.
David Pannell, The University of Western Australia
Muito bom o artigo, muito esclarecedor.
Thanks professor
Thank you sir
Thanks sir
But a question
Why 40% which is the expensive one become the budget chosed for the solution of the problem as was the in the case study
It was chosen by the people responsible for managing the lakes without any serious consideration what the cost of achieving it would be. That is not an approach I would recommend.
I have some difficulty with this. Firstly, you dismiss the economies of scale argument with a throw away comment. For me, economies of scale apply very widely in the production process and undermine the idea that marginal costs always rise with extra production.
Secondly, the main argument seems to be that the cost of gathering the low-hanging fruit is always cheaper than clearing the whole tree, so we should collect the low-hanging fruit of 4 trees rather than clear 1 tree, The reduced costs are more or less certain and probably clear to many people without economic analysis. If we think of an example of clearing an invasive species from an island or destroying mosquitos to stop malaria, it is clear that sure it is cheaper to kill 1/2 the pests or mosquitos and that to kill the last 10% will be vastly more expensive than killing the 1st 10%. But leaving the last 10% behind to reinfect the area is a very poor outcome and more expensive in the long term than biting off the high marginal cost of eradicating the last 10%. The argument is almost, “Let’s do 2 jobs badly rather than 1 job well, because it’s cheaper.”
Economies of scale mean that as the scale of a production process increases, the average cost of a unit of output falls (total cost divided by total number of units of production). An example where this could happen is where you have high fixed costs (costs that don’t depend on the quantity of output produced) and relatively constant variable costs (as the quantity of production increases, the additional costs per extra unit of production don’t increase greatly). As you increase production, the fixed costs get shared over a larger number of units, so the average fixed costs fall, and if the fixed costs are a large enough share of the total costs, then the average total costs can fall. It’s the large fixed costs that are key to this.
Thinking about environmental projects, I can’t think of examples where the fixed costs are particularly high. Generally, the costs are predominantly variable costs, and there is no reason to expect the average variable costs to decline as scale increases. On the other hand, there are strong reasons to expect them to increase. The driver behind the upward slope of the graph above is the increasing costs of achieving additional pollution abatement as you go to higher levels of abatement. All of the published results I’ve seen are similar to this. If you can think of a real example that goes the other way, I’d love to see it. (I note that in your second comment, you accept that marginal costs would increase in the mosquito example you mention.)
In response to your second point, let me clarify that I am only talking about the cost side of the issue in this post. To reach a conclusion about whether it is best to do 10% of a job or 50% or 90% or 100%, you need to consider the benefits too. Making comments about the shape of the cost curve alone is not saying anything about whether any particular target level is best. That also depends on the shape and position of the benefits curve. My only point here is that the shape of the cost curve matters, not that it is the only thing that matters.
Have a look at PD183 (https://www.pannelldiscussions.net/2011/03/183-diminishing-marginal-benefits-of-environmental-projects/), which talks about the benefits side, and PD184 (https://www.pannelldiscussions.net/2011/04/184-the-optimal-scale-of-environmental-projects/), which brings the costs and benefits together. I note that the shape of the benefits curve in PD183 might not be realistic for a pest eradication problem because, as you say, achieving full eradication delivers big cost savings.
p.s. “For me, economies of scale apply very widely in the production process and undermine the idea that marginal costs always rise with extra production.” Well, the empirical reality is that they do almost always rise. If the price of wheat rises, what would you expect farmers to do? Produce more wheat! Supply curves are generally upward-sloping. If you agree with that, then you agree that the marginal cost of production increases with quantity, because the supply curve is (approximately) the marginal cost curve.
Increasing marginal costs is one of the most fundamental ideas in economics. It is the first thing you learn about when studying the economics of production. To force more output out of a given production process, you may have to pay workers more in overtime, or pay more for inputs, or use a more expensive production system, or reduce production of something else that was making you money, so the cost of production goes up.