Content
Review of Key Concepts from Guest Lecture
Gross Ecosystem Product
The guest lecturer discussed GEP, or gross ecosystem product, which involves examining not just what the economy produces, but also what the environment produces for us that is of value to us. This concept is both very new and growing in popularity. To provide context, GEP is one of the three legs of a major grant proposal with a preliminary commitment of $1.5 million in funding. This funding supports research assistants, graduate students, and various other expenses. The GEP concept has practical applications and is gaining traction in the field, which is why the guest lecture was necessary while funding arrangements were being finalized.
The Sustainability Paradox
The guest lecturer also discussed the sustainability paradox, which questions whether economic growth and sustainability can coexist. Key tensions were identified where growth improves welfare, connecting back to previous discussion of the circular growth diagram and how GDP grows as investment in capital stock increases. The tension arises because this growth uses resources, causes pollution, and creates all the environmental challenges that motivate environmental economics as a field.
Why GDP Is a Good Metric
Before examining the downsides of GDP, it is worth acknowledging why GDP has value as a metric. There are two main reasons GDP is useful. First, people like to consume things. People like electricity, fancy cars, and other goods. The entire basis of utility maximization is premised on the idea that more consumption is always good. Second, GDP growth can address equity concerns. If GDP growth is targeted to low-income countries, it can help level out some of the inequity in the world. In other words, allowing Gambia to grow its GDP addresses important equity concerns.
Why GDP Is a Bad Metric
Flow Versus Stock
A fundamental issue with GDP centers on the fact that GDP is a flow, not a stock. A flow is a value that occurs every time period. Income is an example of a flow since a paycheck arrives every pay period and new income constantly flows in. A bank account is a stock, and the income flows into the account and hopefully grows the size of that stock, depending on spending.
This distinction matters because people often incorrectly think that the flow value is what matters most. It feels good to cash a paycheck and see a big increase in available spending. Humans may have an inherent tendency to focus on the flow.
However, when a big medical bill comes due or an unexpected expense arises, what matters is the stock, not the flow. The bill is paid from the bank account stock. It does not matter if the flow is higher than the payment needed if the stock does not currently have sufficient funds. There are ways to convert between flow and stock, such as payment plans that spread costs over several months, but ultimately the stock is generally more important to actual well-being.
GDP is no different and only measures the flow of economic productivity, not the overall wealth of society.
Counting Bads as Goods
One major downside of GDP is that it counts all sorts of things that would intuitively be considered bad as goods because they represent spending.
When a hurricane hits a coastal community, floods the levees, causes people to vacate their houses, destroys communities, and leaves people unable to move back in, this feels like a bad thing. But the hurricane increased GDP. This happens because suddenly there is tremendous demand for rebuilding those houses. The hurricane led to a big burst in the flow variable, the production of new houses. But it simultaneously resulted from the hurricane eliminating much of the stock of those houses. This creates a paradox where hurricanes are good for GDP even though they seem bad. This reflects a fundamental conflict between production and well-being.
Other examples include medical costs from illness, which represent positive GDP. Going to the emergency room and receiving expensive emergency procedures will increase GDP, but the patient certainly did not want that to happen. Similarly, pollution cleanup costs money, which is a bad thing, but it drives up GDP.
Ignoring Non-Market Production
GDP ignores a great deal of valuable activity. Anything that is non-market production never enters into the calculation of gross domestic product. This is straightforward: GDP is defined as the price of something that has been produced multiplied by the quantity produced. If something never enters a market and is never traded, there is no price.
Household labor is an example. Unless payment is made for formal market services like house cleaning, the substantial time spent cleaning houses does not get measured in GDP, even though it certainly has some impact on well-being. There is considerable disagreement about how much this matters, as some people are not bothered by messy houses while others have welfare greatly affected by messiness.
Ecosystem services also are not measured in GDP. Clean skies and a beautiful mountain vista with a clear view to a shining lake are really valuable, but there is no price on them, or at least not a price on all of these values. If only GDP is considered, these things do not matter.
It might be argued that people pay money to travel to scenic spots. That travel spending will register in GDP. The park entrance fee will count. But these market valuations are almost always a huge underestimate of the full value.
Volunteering is another example of non-market activity. From a GDP perspective, volunteering is worthless. This demonstrates that people are not truly rational utility maximizers, because if they were, volunteering would be the worst thing to do. A rational utility maximizer would be wasting time giving well-being to somebody else. This pokes fun at standard economic assumptions, because something does drive people to want to do volunteer work and it feels good. Utility functions are wrong without somehow addressing this.
Silent on Distribution
GDP is silent on distribution. If GDP were used as a metric in a society where a Julius Caesar type figure owned 95 percent of the wealth and all the rest of the population owned a tiny amount, summing up total productivity would essentially mean counting how many expensive bottles of caviar Julius Caesar consumed as the main component of GDP.
If that unequal society has more total production value than a society where everybody has an equitable share and everyone is doing well, GDP as a metric would say the Julius Caesar example economy is better. But this feels wrong. There are very strong reasons to think it is not correct. Highly unequal societies can experience other bad outcomes such as revolutions, wars, and peasant uprisings throughout history. Inequality is by itself potentially a bad thing.
Natural Capital Is Included Wrongly
Natural capital will be emphasized heavily throughout the rest of this course. But even natural capital itself is included in GDP wrongly. It is not just ignored but is actually counted incorrectly when the previous problems are combined.
If timber is harvested and all forests are cleared through deforestation, that is good for GDP because timber was produced. But the challenge is that it reduces the forest stock. Even ignoring everything else, less timber will be available in the future.
The same applies to oil. Extracting it is great for GDP in the short run, but then less is available in the future. Fishing, climate stability, and many other natural resources have the same problem.
The Importance of Time in Evaluating GDP
GDP Is Bad Even for People Who Hate the Environment
There is another important reason why GDP is a bad metric that many people do not appreciate. GDP is bad as a metric even from the perspective of someone who does not care about the environment at all.
Suppose someone truly assigns a zero value to beautiful vistas, fishing, hunting, or anything else the environment provides. Suppose this person literally only cares about economic production. Who is this person? It is someone who maximizes utility, exactly the type of person being discussed in standard economics.
As soon as a new element is added, namely time, that alone is sufficient to show that GDP as a flow variable is a bad metric. Nothing about the environment is needed for this conclusion, just time itself.
What if this selfish person that does not care about the environment considered burning everything down in the first period? What about the next period? Even without caring about the environment, this person probably cares about consumption not just right now but also in the next time period, and the period after that.
Standard economics, ignoring environmentalism, immediately moves into incorporating time through net present value, or NPV. Any accounting course covers NPV as one of the first topics. When choosing whether to invest a large amount of money in a project that will pay out value far in the future, consideration must be given not just to how much it pays out 30 years from now, but to the net present value of that future payment.
The key insight is that a million dollars 30 years from now is not worth as much as a million dollars right now. Things in the future are worth less than things in the present, assuming a positive interest rate. But the future cannot be ignored entirely. Just because something is not being consumed today does not mean it is worth nothing.
Even someone who only cared about GDP would not want to just maximize GDP in the first year. What such an anti-environmentalist would really want to maximize is the net present value of the flow of GDP over time.
The Discount Rate
Definition and Formula
The discount rate is central to accounting courses and has connections to important variables like the interest rate and mortgage rates that matter in everyday life. In the environmental context, the discount rate will be used in new circumstances beyond mortgage payments, such as trying to determine the optimal amount of climate change to allow or the optimal number of species to let go extinct.
The discount rate, or some understanding of how much the future matters relative to the present, may be the most important number for the fate of the world. This is not entirely a joke. What should be done about the climate crisis depends entirely on the discount rate.
The discount rate is a relationship between present value and future value. It links these values over time according to an assumption about how much different values matter, comparing the present value to the future value, using the variable R for the discount rate.
The equation is straightforward. The present value of some investment choice equals the future value divided by the quantity one plus R raised to the power of T, where T is the number of time periods. For example, the present value of building a factory that does not start producing until year 10 would convert the future value, say a million dollars, to present value by dividing by one plus the discount rate raised to the 10th power.
If R is zero, then one plus zero equals one, and one raised to any power stays one. At a discount rate of zero, future value equals present value. This would be the unusual case where it does not matter whether the million dollars is received right now or 10 years in the future.
With a higher discount rate, such as 3 percent or 0.03, the denominator would be 1.03 raised to the power of the number of years. For each additional year into the future, this denominator gets bigger and bigger, so the future value is divided by a larger number, meaning it is worth less.
The intuition from this equation is that a dollar today is worth more than a dollar tomorrow, because a positive interest rate makes the future worth less.
Negative Interest Rates
Negative interest rates do occur in practice, typically when policymakers are trying to promote economic growth. The assumption that R must always be positive may be too strong. There are observations in real life and hypothetical situations where a negative discount rate could apply.
Another example would be if the apocalypse is known to be coming; it would make sense to spend everything now rather than wait for the future. In general, however, for business investment decisions like whether to buy a new factory, companies always have a positive interest rate and positive discount rate because they have impatient stockholders that want their return on investment now rather than in the future.
Why People Discount
Pure Time Preference
The first reason people discount is pure time preference. Independent of investment opportunities or other factors, people simply prefer things now. A famous experiment tried to establish the time preference rate for toddlers.
In this experiment, a toddler of about two or three years old is placed in a room and given a marshmallow. The child is told they can eat this marshmallow, but if they wait 10 minutes while alone in the room and the marshmallow is still there when the experimenter returns, they will receive three marshmallows. The experiment tracks which toddlers decide they want the marshmallow now even though they know more marshmallows will come later.
The videos of these experiments are entertaining because the toddlers struggle intensely, sitting on their hands, trying not to look at the marshmallow, hiding from it, and putting things on top of it to resist the urge to consume the treat. The toddlers clearly understand they will get more sugar later if they wait, but something causes them difficulty. Their mouths are salivating and basic human instincts are not good at thinking far into the future when a tasty morsel is right in front of them. People prefer consumption now rather than later, and this can be observed repeatedly.
Pure rate of time preference is isolated from other factors. It represents just the preference for having the marshmallow now versus in the future.
Investment Opportunity Cost
Even if someone did not care about when they received money, a profit-maximizing person would still prefer a million dollars right now over a million dollars 10 years from now. The reason is that other things could be done with the money besides investing in a specific factory.
Alternative uses include paying off student loans, buying stocks, or putting money in a bank to earn interest. Having a million dollars now means it can be placed in whatever financial instrument is available. Paying off student loans immediately reduces future payments. Investing generates a return on investment from the bank.
This reflects an opportunity cost of not investing. If funds are used elsewhere, there is a cost to not putting them in a direct return option.
Growth and Intergenerational Equity
Dynamic elements of growth also affect discounting. If a future generation is much richer than the present generation, a dollar to them is not worth as much. This reflects the law of diminishing marginal utility. If the future is expected to be exponentially richer, there is a question of whether saving money for ultra-wealthy interplanetary species descendants makes sense when that money could instead provide electricity to Gambia today.
This cuts both ways, however. What if the future is much worse? Spending a dollar on a trivial luxury today might seem unfair if 100 years from now descendants will be living in climate catastrophe-induced poverty. Those future generations could actually use that dollar much better.
Intergenerational inequality aspects come into play. How much people care about future value depends in part on how much they care about their grandchildren. Someone who really cares about grandchildren, even potential future grandchildren, wants the world to be a nice place for them. This changes behavior now.
Current actions like investing in children’s college funds reflect this concern for future generations being better off, with the hope that they can in turn help their own grandchildren. Most people show some degree of caring about future generations. If there is care for grandchildren or other people’s grandchildren, the discount rate will differ. Value going to grandchildren will be worth a little bit more, which is reflected by having a discount rate that is a little bit less, making future value worth more.
The Impact of Different Discount Rates
Numerical Example
Different discount rates drastically affect what environmental policies are optimal. Consider $1,000 received in 100 years. What would the present value be today?
The equation is: present value equals $1,000 divided by one plus R raised to the 100th power.
With R equal to 1 percent, or 0.01, raising 1.01 to the 100th power and dividing $1,000 by that result gives $369 today. The value decreased, but $369 is still a reasonable investment.
With a 5 percent discount rate, the same calculation results in $7.60.
The same investment option with different interest rates and time preferences produces a huge difference. The further into the future, the more this difference amplifies exponentially.
Implications for Future Investments
With a high discount rate, almost no investment in the future is worth it. A project that saves humanity from climate change with outcomes 100 times better 100 years from now might still not be worth doing with a big discount rate. It will fail a cost-benefit analysis because according to discounting logic, large future values shrink to tiny numbers in present value terms.
This is especially important for climate economics. Much of the answer to what should be done for climate change depends entirely on the discount rate and nothing else. This is somewhat depressing because the discount rate is a value reflecting how selfish or not people are, rather than some sort of optimal value that can be figured out objectively.
Utility Maximization Dynamic Game
Game Overview
To illustrate discount rate concepts, an interactive game demonstrates utility maximization over time. The game involves making consumption choices in each time period, and total utility is summed over 12 periods.
Scenario 1: Static Optimization
The first scenario reviews static optimization. This is a reminder of how to optimize consumption choices over time. The indifference curve should be tangent to the budget constraint to get maximum utility. Points inside the budget constraint are feasible but produce less utility than optimal. Points outside are not affordable. Instead of toggling X and Y goods, clicking selects the consumption levels of good X versus good Y.
Market news drives changes in the game environment. Tariff rates change, income goes up from raises, prices change affecting the budget constraint slope, competitors enter the market benefiting consumers, car repairs reduce income, health kicks change preferences, and supply shortages reduce utility like the COVID shock affecting toilet paper availability.
The winning strategy is getting as close as possible to where the indifference curve is tangent to the budget constraint, being both on the line and in the right spot.
Scenario 2: Investment and Growth
The second scenario adds the option of lower consumption in one period, which is bad for current utility, but allows investment. Money not spent goes into the bank and earns interest, returning that amount plus 20 percent additional money in the next period as a higher budget.
This scenario is more interesting because it requires thinking about optimal investment strategy. The same series of shocks occur as in the first scenario.
The winning strategy involves going to zero or very low consumption early to build up the budget substantially, then switching to spending as much as possible in later periods. If zero consumption continued until month 12, utility would be zero, which is not worthwhile. At some point, switching to high spending maximizes total utility across all periods.
Scenario 3 and Beyond: Incorporating Discounting
The second scenario was somewhat unfair because it included the positive aspects of investing but left out an important element. The fact that money in the future has less value, and that not spending anything at all would mean starvation, was not included. The discount rate that adds this realism will be incorporated in additional scenarios.
Conclusion
This lecture introduced inclusive wealth concepts and examined GDP as a metric in detail. Key limitations of GDP were identified, including its nature as a flow variable, its counting of bads as goods, its ignoring of non-market production, its silence on distribution, and its incorrect treatment of natural capital. The concept of discounting was introduced as essential for thinking about time and environmental decisions. The discount rate emerges as perhaps the most important number for environmental policy, particularly for climate economics, even though it reflects values about selfishness and care for future generations rather than objective optimization.