November 29, 2022

The Cost of Growth

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Externalities and the cost of growth

The Classic and Neoclassic economists talked about the cost of economic growth. Malthus in 1826 and Stuart Mill in 1893, both recognized that unbridled expansion would be difficult in a world with limited natural resources and traditional economic mechanisms could not assure everyone’s well-being. The former predicted an exponential increase in population, resulting in famine and war. The latter foresaw the depletion of natural resources as a risk of competitive capitalism leading to people trampling and treading on each other.

In modern terms, the argument is understood under the name of Pareto optimal, in an economy with competitive free-market equilibrium comes at the point where it becomes impossible to improve the economic welfare of anyone without making someone else worse off.

Philosopher and economist Henry Sidgwick followed in the steps of John Stuart Mill and articulated in utilitarian terms the potential conflicts arising between human self-interest and the interest of society to maximize overall wealth. Arthur Pigou formalized this line of thinking into the concept of externalities in 1920 with his work The economics of welfare. Pigeou defined externalities as the effect of the economic activities of one party that directly affects other people or society as a whole. Some of the clearest examples he provides of negative externalities are the cases of air or water pollution. His proposal of a tax equal to the marginal external cost, later named a Pigouvian tax, was meant to reduce the incidence of negative externalities.

In 1960 Coase wrote The problem of social cost. This book builds on Pigou’s concept and reframes the issue as one of a reciprocal nature. It explores ways to deter businesses from harming third parties or to compensate them for the harm. According to Coase, Pigou’s approach is inherently flawed and a new approach is needed: one that looks at the total cost, which includes operation costs as well as the cost of changing systems. Coase’s work on social cost received significant attention, yet it overlooked the work of one of the pioneers of Ecological Economics, William Kapp. Kapp published the first systematic record of social costs in his work The Social Costs of Private Enterprise in 1951.

Kapp offered an alternative view to the neoclassical theory of externalities described by Pigou and Coase and defined social costs as “all direct and indirect losses sustained by third parties as a result of unrestrained economic activities, such as damages to human health, property valuables, depletion of natural resources or less tangible values”. A major contribution Kapp made to economics was that he rejected the idea of quantifying social costs and benefits and advocated humanizing economics starting with universal human needs. In order to prevent social costs from happening, we would need legal and institutional regulations and standards, instead of trying to fix the issues after they happen.

Another point of criticism to neoclassical economics came on the grounds of thermodynamics, in 1971 when Nicholas Georgescu-Roegen published his book The Entropy Law and the Economic Process. Using thermodynamics, we begin to understand economic growth differently. As the social and natural sciences begin to integrate into economics, we realize the economy is part of a larger system on the planet, where everything is interconnected. There are no externalities in this ecosystem perspective.

Through the eyes of these modern economists we see an insightful reevaluation of the Neoclassical concept of economic growth. Its role as goal and measuring stick proves both insufficient to increase wellbeing or quality of life, and the root cause of issues such as pollution of air and water, traffic congestion, inequality, and an increase in consumption aimed at justifying increased production, rather than satisfying needs. These issues can no longer be swept under the rug as external to economic inquiry. Understanding that the economy is a subsystem of a larger system and that it cannot grow beyond the boundaries of the latter, proposes a significant challenge to the idea that growth is the most important economic goal of a modern society.

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