Monday, February 25, 2008

Can Economics Solve the Problem of Global Warming?

The potential negative effects of global warming are very serious. Even by just concentrating on economic factors, global warming has the potential to cause unprecedented costs to the global economy (According to Stern Report 20% of global output could be lost over the next few decades) (1). Yet, despite the forecasted dangers and economic costs, there seems to be an inertia in implementing necessary policies to avert the consequences of global warming.

These are some of the reasons why it is difficult to deal with the issue of global warming.

Free Rider Problem.

Global warming is by definition a phenomenon which affects every country. Pollution may be caused by a small % of developed countries and yet those who suffer the most maybe pacific islands who contribute nothing to global warming. When it comes to reducing carbon emissions there is a classic free rider problem. Countries can benefit from lower emissions by relying on other countries to make sacrifices and reduce their pollution levels. The problem is that countries can then become reluctant to start reducing emissions until other countries start reducing emissions as well. Why should a tiny country like Sweden make sacrifices in reducing carbon emissions, if the US continues to create 25% of the world's CO2 emissions?


Global warming is to a large extent caused by externalities. When you drive an SUV, the contribution to global warming is an external cost which you don't experience personally. Free markets are notoriously bad at including external costs in prices. The consequence is that there is over-consumption of goods which pollute and cause global warming. In theory, economics has a solution to the problem of externalities. If you can work out the external cost of driving an SUV, you can place a suitable tax to make people pay the social cost and reduce demand to the socially efficient level. The difficulty is working out and then agreeing on a suitable external cost. If the real cost of global warming is as high as the Stern report indicates, it would suggest carbon emitting vehicles are seriously undertaxed and the social cost of carbon emissions is much higher than current legislation suggests. The difficulty then also becomes convincing the general public that due to the external costs of pollution we need a 100% increase in petrol tax.

Intergenerational externalities.

Another problem of global warming is the issue of intergenerational externalities. The current population is benefiting from the consumption of fossil fuels and is unlikely to face the worst consequences of global warming. The problem becomes trying to reflect future costs in today's prices. This is one area where policymakers and economic theory has placed very little emphasis in the past. The traditional economic models consider issues as being static and tend to place less emphasis on activities which increasingly create costs in the future.

The economics of Uncertainty.

Another problem with global warming is that there is tremendous uncertainty about the future costs of global warming. The Stern report suggested a particular economic cost but in reality, it could be less, but, it could also be a lot more. For every report which suggests global warming will be a real problem, it will always be possible to create an alternative report, (perhaps by people who don't really want to accept the potential cost of global warming.)

However, given the uncertainty of global warming, the rational solution would be too risk-averse. i.e. assume the worst and take steps to avoid it. Instead, people seem to prefer to take the risky option of assuming that the outcome may be much better than many reports predict; if this is the case then future generations will not suffer; but, if our gamble is misplaced future generations will bitterly regret the decisions of the present generation. This risk-taking approach to global warming goes against what we see in usual rational behaviour. For example, people take out home insurance to protect against the (very small ) risk of a house burning down. On a global scale, we have quite a high risk of serious global disaster, but people are very reluctant to take the necessary steps to avoid it.

How Could Economists help in Changing Attitudes to Global Warming?

  • Emphasise the nature of Market failure for this particular issue.
  • Explain the importance of external costs in justifying higher taxes on carbon emissions and corresponding subsidies for alternatives.
  • Place greater emphasis on intergenerational economic issues.
  • Critique of old growth paradigms which equate improved living standards to increased GDP
  • Emphasise the rationality of insuring against worst possible outcomes rather than risking the chance that the worst will not happen.
  • Emphasise why countries should act, irrespective of the decisions of other countries.

More on Economics of Global Warming

Is global warming happening in the UK?


(1) Stern Report on Global Warming

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