Lecture Changing perspectives on the environment

The Economic System in an Environmental Context

A basic building block of mainstream economic theory is the standard circular flow model of an economic system. As illustrated in Figure 1.1, this simple model depicts the relationships between households and business firms in two markets: the market for goods and services and the market for factors of production. Factors of production are generally defined as land, labor, and capital. The services that these factors provide are “inputs” into the production of goods and services, which in turn provide for households’ consumption needs. Goods, services, and factors flow clockwise; their economic values are reflected in the flows of money used to pay for them, moving counterclockwise. In both markets, the interaction of supply and demand determines a market-clearing price and establishes an equilibrium level of output.

Where do natural resources and the environment fit in this diagram? Natural resources, including minerals, water, fossil fuels, forests, fisheries, and farmland, generally fall under the inclusive category of “land.” The two other major factors of production, labor and capital, continually regenerate through the economic circular flow process, but by what processes do natural resources regenerate for future economic use? Environmental economists recognize that it is necessary to address the limitations of the standard circular flow model in this respect. But ecological economists place a particular emphasis on a broader circular flow model that takes into account ecosystem processes as well as economic activity (Figure 1.2).

Taking this broader view, we notice that the standard circular flow diagram also omits the effects of wastes and pollution generated in the production process. These wastes, from both firms and households, must flow back into the ecosystem somewhere, either being recycled, through disposal, or as air and water pollution.

In addition to the simple processes of extracting resources from the ecosystem and returning wastes to it, economic activities also affect broader natural systems in subtler and more pervasive ways not illustrated in Figure 1.2. For example, modern intensive agriculture changes the composition and ecology of soil and water systems, as well as affecting nitrogen and carbon cycles in the environment.

Figure 1.2 provides a broader framework for placing the economic system in its ecological context. Natural resources include both renewable and nonrenewable resources. Renewable resources are those that are regenerated over time through ecological processes, such as forests and fisheries. Renewable resources can be managed sustainably if extraction rates don’t exceed natural regeneration rates. However, if renewable resources are overexploited they can be depleted, such as species that go extinct through over-harvesting. Nonrenewable resources are those that do not regenerate through ecological processes, at least on a human time scale. Nonrenewable resources such as oil, coal, and mineral ores are ultimately available in a fixed supply, although new resources can be discovered to expand the known available supply. The other input into the economic system is solar energy, which as we will see later in the text provides a limited but incredibly abundant source of continual energy.

What does this expanded circular flow model imply for economic theory? There are at least three major implications:

1. 
   The recognition that natural resources and solar energy provide the essential input into economic processes implies that human well-being is ultimately dependent on these resources. Measuring well-being using standard economic metrics, such as gross domestic product, understates the importance of natural resources. This suggests a need for alternative indicators of well-being.
   
2. 
   As shown in Figure 1.2, the ecological system has its own circular flow, which is determined by physical and biological rather than economic laws. This broader flow has only one net “input”—solar energy—and only one net “output”—waste heat. Everything else must somehow be recycled or contained within the planetary ecosystem.
   
3. 
   In the standard circular flow model, the economic system is unbounded and can theoretically grow indefinitely. But in the expanded model, economic activity is limited by both the availability of natural resources and the ability of the environment to assimilate wastes and pollution. Thus the overall scale of the economy relative to the available natural resources must be considered.
   

As with some of the other questions we have discussed, there can be significant overlap between environmental and ecological economics perspectives on these issues. In terms of the double circular flow shown in Figure 1.2, a standard environmental economics perspective starts from the inner, economic, circle and tries to understand broader ecological issues in economic terms. Ecological economists place greater emphasis on the outer circle, with its biophysical laws and limitations, but are also aware of the importance of the way resources and the environment are taken into account in economic analysis.