`Global Climate Change: A Challenge to Policy’, by a Nobel laureate Kenneth J . Arrow , in 2011.

MPE 781- Economics for Managers
Trimester 2, 2017
Assignment: Economics Case Study
Due on the 5th of September (11:59 pm), 2017.
I. Assignment Overview: This assignment is based on an article pub-
lished in The Economists’ Voice titled `Global Climate Change: A Challenge
to Policy’, by a Nobel laureate Kenneth J . Arrow , in 2011. The article is
already attached to this assignment question. Please read the article care-
fully before attempting this exercise. You will also need to draw on other
resources available through the library as well as external resources. Please
note that you need to provide clear references for your sources when citing
research and data.
II. Learning Objectives: This assignment is designed to encourage
you to think about the application of concepts learned in this unit in a real
world scenario. This assignment, indeed, is interesting as it explains the
mechanism that leads to global warming and its impacts on our economy.1
1Note that the article refers to this phenomenon as global warming but in recent years,
the scienti c community and journalism have begun to refer to it as climate change, which
is the term you may be familiar with. You may use either term, but use only one.
1
Furthermore, this assignment also addresses the challenge that we face to
implement e ective economic polices to reduce the magnitude of impacts of
global warming. We hope that this assignment will expand the horizon of
your thoughts.
III. Assessment: Your score on this assignment contributes towards
40% of your nal score for this unit. Your assignment will be graded on
your use of appropriate economic theory and concepts; relevant diagrams
and clarity of exposition and overall quality of your answers. Although you
can work in group, this is not a group assignment and you must submit
answers individually.
IV. Submission: This assignment must be submitted electronically on
CloudDeakin (CD) Dropbox area by 11:59 pm on the due date. No hard
copy submission will be graded. Print your name and student ID clearly
on the rst page of your answers. Please check the Academic Honesty and
Misconduct section in the Unit Guide. Submitting your answers automati-
cally implies that you have read and accepted the Plagiarism and Collusion
Declaration, and that the submitted answers are entirely your own work.
V. Questions: Answer all questions. Limit the total word count of
your assignment to less than 3,000 words. You are encouraged to provide
necessary graphs, gures and tables with data wherever possible, which are
not subject to word limit. Please be careful in implementing referencing
styles.
1. In no more than 150 words, motivate the reader to read the article by
summarising the key assumptions and main points. [8 marks]
2
2. According to Arrow, \We are much better to act to reduce CO2 emis-
sion substantially than to su er and risk the consequences of failing to
meet this challenge.” { in light of the article and based on your own
research, please explain why he suggests so. Speci cally, what sources
of market failure are present? Apply the abstract possible solutions to
this problem of global warming. [8 marks]
3. In this article, the consumption discount rate, denoted by , is de ned
as  =  + g. What do the terms  and g represent? Explain the
intuition behind this equation. One critique says that any kind of
uncertainty regarding g may lower the value of . Do you agree or
disagree with the critique? What are the implications to the economy
of having a lower value of , when human-induced global warming is
occurring? Explain. [ 8 marks]
4. Adam Morton, in his article titled \Energy crisis: Wholesale power
prices have doubled since the carbon tax was axed” published in the
Sydney Morning Herald (dated the 9th March, 2017), has argued that
the dramatic increase has been largely blamed on soaring gas prices
and investment uncertainty over what power plants to build as age-
ing coal generators shut down. If so then what are the implications
regarding the value of  for Australia? Explain. [8 marks]
5. In the equation  =  + g, assume that  is determined by an action
of a social planner. Consider the event when U.S. President Donald
Trump withdrew the U.S. from the Paris Climate Accord on June 1st,
2017. What are the implications regarding the value of  for the world?
Explain. [8 marks]
3
Additional References
1. Morton, Adam (2017). \Energy crisis: Wholesale power prices
have doubled since the carbon tax was axed.” http://www.smh.com.au/
federal-politics/political-news/energy-crisis-wholesale-power-prices-
have-doubled-since-the-carbon-tax-was-axed-20170308-gutf8t.html)
2. Stern, Nicholas. (2006). The Economics of Climate Change, The
report is accessible from the following source:
http://mudancasclimaticas.cptec.inpe.br/~rmclima/pdfs/destaques/
sternreview_report_complete.pdf
3. Various Data Sets regarding the recent trend of Global Warming
can be accessible from the following source: https://www.ncdc.noaa.gov/
monitoring-references/faq/global-warming.php
4
13
CHAPTER 2
Global Climate Change:
A Challenge to Policy
Kenneth J. Arrow
LAST FALL, THE United Kingdom issued a major government report
on global climate change directed by Sir Nicholas Stern, a top- fl ight
economist. The Stern report amounts to a call to action: it argues
that huge future costs of global warming can be avoided by incurring
relatively modest costs today.
Critics of the Stern report don’t think serious action to limit carbon
dioxide (CO2) emissions is justifi ed because there remains substantial
uncertainty about the extent of the costs of global climate
change and because these costs will be incurred far in the future.
They think that Stern improperly fails to discount for either uncertainty
or futurity.
I agree that both futurity and uncertainty require signifi cant
discounting. However, even with that, I believe the fundamental
Kenneth J. Arrow won the Nobel Memorial Prize in Economics in 1972. He is the
professor of economics emeritus and professor of management science and engineering
emeritus at Stanford University. He thanks the Hewlett Foundation for research
support.
The Economists’ Voice, edited by Joseph E. Stiglitz, et al., Columbia University Press, 2011. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/deakin/detail.action?docID=3029387.
Created from deakin on 2017-07-03 21:10:08.
Copyright © 2011. Columbia University Press. All rights reserved.
14
conclusion of Stern is justifi ed: we are much better to act to reduce
CO2 emissions substantially than to suffer and risk the consequences
of failing to meet this challenge. As I explain here, this
conclusion holds true even if, unlike Stern, one heavily discounts
the future.
A PERSONAL INTRODUCTION TO GLOBAL WARMING
I fi rst heard of the effect of industrialization on global temperatures
long before the present concerns became signifi cant: in the fall of
1942, to be precise. I was being trained as a weather offi cer. One
course, called “dynamic meteorology,” taught by Dr. Hans Panofsky
at New York University, dealt with the basic physics of weather systems
(pressure variations, the laws determining the strength of
winds, the causes and effects of precipitation, and similar matters).
One of the fi rst things to understand was what determines the general
level of temperature. The source of terrestrial temperature is of
course solar radiation. But heating of the earth from the sun’s rays
causes the earth to emit radiation at frequencies appropriate to its
temperature, that is, in the infrared low- frequency portion of the
electromagnetic spectrum. Since the earth radiates into empty space,
where the temperature approximates absolute zero, it would appear
that in equilibrium the earth should come to that temperature also,
as is indeed the case with the moon.
What makes the difference is the earth’s atmosphere. The vast
bulk of the atmosphere is made up of nitrogen and oxygen, transparent
to both the visible radiation coming from the sun and the infrared
radiation emitted by the earth and hence without effect on the
equilibrium temperature. However, the atmosphere also contains,
we learned, a considerable variety of other gases in small quantities.
These “trace gases” include most notably water vapor, carbon dioxide,
and methane, though there are many others. These trace gases
Global Warming
The Economists’ Voice, edited by Joseph E. Stiglitz, et al., Columbia University Press, 2011. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/deakin/detail.action?docID=3029387.
Created from deakin on 2017-07-03 21:10:08.
Copyright © 2011. Columbia University Press. All rights reserved.
Global Climate Change 15
have the property of being transparent to radiation in the visible part
of the spectrum but absorbent at lower frequencies, such as infrared.
Hence, the effect of these gases is to retain the outgoing radiation
and so raise the temperature of the earth to the point in which life
can fl ourish. The effect is strictly parallel to the use of glass in greenhouses,
also transparent to visible radiation but not to infrared; hence,
the widespread term, “green house effect.”
Where do these trace gases come from? The water vapor comes
from the passage of air over the large expanses of water in the earth’s
surface, particularly when the water is warmer than the air. The carbon
dioxide and methane come from some nonbiological sources,
such as volcanic eruptions, but also from the respiration of animals
and from organic wastes. (Vegetation, on the contrary, absorbs CO2.)
Our instructor then added one more observation. CO2 is a byproduct
of combustion. There are fi res due to volcanoes and lightning,
and mankind has lit fi res for 500,000 years, but the pace of
combustion has vastly increased since the Industrial Revolution. So,
concluded Dr. Panofsky, we can expect the world temperature to
rise steadily as CO2 continues to accumulate and at an increasing
rate with the growth of industry. This was not presented as a jeremiad
or as controversial. Indeed, we were clearly being told this to
vivify the quite arid set of facts we had to learn rather than to move
us to action.
As any economist accustomed to general equilibrium theory
might guess, the implications of a given increase in green house gases
for the weather are mediated through a very complex interactive system
with both positive and negative feedbacks. Elaborate climate
models have been developed, each admittedly falling short of catching
some signifi cant aspect. (Economists will understand.) Nevertheless,
serious studies have lead to a considerable consensus,
although with a wide range of uncertainty. I draw upon the most recent
report, prepared by a team directed by Sir Nicholas Stern for the
United Kingdom prime minister and chancellor of the exchequer
The Economists’ Voice, edited by Joseph E. Stiglitz, et al., Columbia University Press, 2011. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/deakin/detail.action?docID=3029387.
Created from deakin on 2017-07-03 21:10:08.
Copyright © 2011. Columbia University Press. All rights reserved.
16
(Stern 2006). The mean levels of different magnitudes in this report
are comparable to those in earlier work, but the Stern report is more
explicit about ranges of uncertainty.
The current level of CO2 (plus other green house gases, in CO2
equivalents) is today about 430 parts per million (ppm), compared
with 280 ppm before the Industrial Revolution. With the present and
growing rate of emissions, the level could reach 550 ppm by 2035.
This is almost twice the preindustrial level and a level that has not
been reached for several million years.
POTENTIAL CLIMATE CHANGE AND ITS IMPACTS
Most climate change models predict that a concentration of 550 ppm
would be associated with a rise in temperature of at least two degrees
Centigrade. A continuation of “business- as- usual” trends will
likely lead to a trebling of CO2 by the end of the century, with a 50
percent chance of exceeding a rise of fi ve degrees Centigrade, about
the same as the increase from the last ice age to the present.
The full consequences of such rises are not well known. Some of
the direct effects are obvious: implications for agriculture (not all
bad; productivity in Canada and northern Rus sia will rise, but negative
effects predominate where moisture is the limiting factor and especially
in the heavily populated tropical regions) and a rise in sea
level, which will wipe out the small island countries (e.g., the Maldives
or Tonga) and encroach considerably on all countries. Bangladesh
will lose much of its land area; Manhattan could be under
water. This rise might be catastrophic rather than gradual if the
Greenland and West Antarctic ice sheets melt and collapse. In addition,
temperature changes can change the nature of the world’s
weather system. A reversing of the Gulf Stream, which could cause
climate in Eu rope to resemble that of Greenland, is a distinct possibility.
There is good reason to believe that tropical storms will be-
Global Warming
The Economists’ Voice, edited by Joseph E. Stiglitz, et al., Columbia University Press, 2011. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/deakin/detail.action?docID=3029387.
Created from deakin on 2017-07-03 21:10:08.
Copyright © 2011. Columbia University Press. All rights reserved.
Global Climate Change 17
come more severe, since the energy that fuels them comes from the
rising temperature of the oceans. Glaciers will disappear, indeed have
been disappearing, rapidly, and with them, valuable water supplies.
ARE THE BENEFITS FROM REDUCING CLIMATE
CHANGE WORTH THE COSTS?
The available policies essentially are ways of preventing the greenhouse
gases from entering the atmosphere or at least reducing their
magnitude. Today the source of 65 percent of the gases is the use of
energy; the remainder arises from waste, agriculture, and land use. A
number of behavioral changes would mitigate this problem: (1) shifting
to fuels that have higher ratio of useful energy to CO2 emissions
(e.g., from coal to oil or oil to natural gas); (2) developing technologies
that use less energy per unit output; (3) shifting demand to
products with lower energy intensity; (4) planting trees and reducing
deforestation, since trees absorb CO2; and (5) pursuing an unproven
but apparently feasible policy of sequestering the CO2 by pumping it
directly into underground reservoirs. We can go further and simply
restrict output.
Two factors deserve emphasis, factors that differentiate global climate
change from other environmental problems. First, emissions of
CO2 and other trace gases are almost irreversible; more precisely, their
residence time in the atmosphere is mea sured in centuries. Most environmental
insults are mitigated promptly or in fairly short order when
the source is cleaned up, as with water pollution, acid rain, or sulfur dioxide
emissions. Here, reducing emissions today is very valuable to
humanity in the distant future. Second, the scale of the externality is
truly global; green house gases travel around the world in a few days.
This means that the nation- state and its subsidiaries, the typical loci
for internalization of externalities, are limited in their remedial ability.
(To be sure, there are other transboundary environmental externalities,
The Economists’ Voice, edited by Joseph E. Stiglitz, et al., Columbia University Press, 2011. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/deakin/detail.action?docID=3029387.
Created from deakin on 2017-07-03 21:10:08.
Copyright © 2011. Columbia University Press. All rights reserved.
18
as with water pollution in the Rhine Valley or acid rain, but none is
nearly so far- fl ung as climate change.) However, because the United
States contributes about 25 percent of the world’s CO2 emissions, its
own policy could make a large difference.
Thus, global climate change is a public good (bad) par excellence.
Benefi t- cost analysis is a principal tool for deciding whether altering
this public good through mitigation policy is warranted. Economic
analysis can also help identify the most effi cient policy instruments
for mitigation, but I leave that to other essays in this issue.
Two aspects of the benefi t- cost calculation are critical. One is allowance
for uncertainty (and related behavioral effects refl ecting risk
aversion). To explain economic choices such as insurance or the holding
of inventories, it has to be assumed that individuals prefer to
avoid risk. That is, an uncertain outcome is worth less than the average
of the outcomes. As has already been indicated, the possible outcomes
of global warming in the absence of mitigation are very
uncertain, though surely they are bad. The uncertain losses should
be evaluated as being equivalent to a single loss that is greater than
the expected loss.
The other critical aspect is how one treats future outcomes relative
to current ones. The issue of futurity has aroused much attention
among phi los o phers as well as economists. At what rate should
future impacts—in par tic u lar, losses of future consumption—be discounted
to the present? The consumption discount rate, δ, can be expressed
by the following simple formula:
δ = ρ + gη
where ρ is the social rate of time preference, g is the projected growth
rate of average consumption, and η is the elasticity of the social
weight attributed to a change in consumption.
The pa ram e ter η in the second term accounts for the possibility
that, as consumption grows, the marginal unit of consumption may
Global Warming
The Economists’ Voice, edited by Joseph E. Stiglitz, et al., Columbia University Press, 2011. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/deakin/detail.action?docID=3029387.
Created from deakin on 2017-07-03 21:10:08.
Copyright © 2011. Columbia University Press. All rights reserved.
Global Climate Change 19
be considered as having less social value. It is analogous to the idea of
diminishing marginal private utility of private consumption. This
component of the consumption rate of discount is relatively uncontroversial,
although researchers disagree on its magnitude. The appropriate
value to assign to η is disputed, but a value of 2 or 3 seems
reasonable (the Stern report uses 1, but this level does not seem compatible
with other evidence).
Greater disagreement surrounds the appropriate value for ρ, the
social rate of time preference. This pa ram e ter allows for discounting
the future simply because it is the future, even if future generations
were to be no better off than we are. The Stern report follows a considerable
tradition among British economists and many phi los o phers
against discounting for pure futurity. Most economists take pure
time preference as obvious. Tjalling Koopmans pointed out in effect
that the savings rates implied by zero time preference are very much
higher than those we observe. (I am myself convinced by this
argument.)
Many have complained about the Stern report adopting a value of
zero for ρ, the social rate of time preference. However, I fi nd that the
case for intervention to keep CO2 levels within bounds (say, aiming
to stabilize them at about 550 ppm) is suffi ciently strong as to be insensitive
to the arguments about ρ. To establish this point, I draw on
some numbers from the Stern report concerning future benefi ts
from keeping green house gas concentrations from exceeding
550 ppm, as well as the costs of accomplishing this.
The benefi ts from mitigation of green house gases are the avoided
damages. The report provides a comprehensive view of these damages,
including both market damages as well as nonmarket damages
that account for health impacts and various ecological impacts. The
damages are presented in several scenarios, but I consider the socalled
high- climate scenario to be the best- based. Figure 6- 5c of the
report shows the increasing damages of climate change on a businessas-
usual policy. By the year 2200, the losses in gross national product
The Economists’ Voice, edited by Joseph E. Stiglitz, et al., Columbia University Press, 2011. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/deakin/detail.action?docID=3029387.
Created from deakin on 2017-07-03 21:10:08.
Copyright © 2011. Columbia University Press. All rights reserved.
20
(GNP) have an expected value of 13.8 percent of what GNP would
be otherwise, with a .05 percentile of about 3 percent and a .95 percentile
of about 34 percent. With this degree of uncertainty, the loss
should be equivalent to a certain loss of about 20 percent. The base
rate of growth of the economy (before calculating the climate change
effect) was taken to be 1.3 percent per year; a loss of 20 percent in the
year 2200 amounts to reducing the growth rate to 1.2 percent per
year. In other words, the benefi t from mitigating green house gas
emissions can be represented as the increase in the growth rate from
today to 2200 from 1.2 percent per year to 1.3 percent per year.
We have to compare this benefi t with the cost of stabilization. Estimates
given in table 10.1 of the Stern report range from 3.4 percent
down to 3.9 percent of GNP. (Since energy saving reduces energy
costs, this last estimate is not as startling as it sounds.) Let me assume
then that costs to prevent additional accumulation of CO2 (and
equivalents) come to 1 percent of GNP every year forever.
Finally, I assume, in accordance with a fair amount of empirical
evidence, that η, the component of the discount rate attributable to
the declining marginal utility of consumption, is equal to 2. I then
examine whether the present value of benefi ts (from the increase in
the GDP growth rate from 1.2 percent to 1.3 percent) exceeds the
present value of the costs (from the 1 percent permanent reduction in
the level of the GDP time profi le). A straightforward calculation
shows that mitigation is better than business as usual—that is, the
present value of the benefi ts exceeds the present value of the costs—
for any social rate of time preference (ρ) less than 8.5 percent. No estimate
for the pure rate of time preference, even by those who believe
in relatively strong discounting of the future, has ever approached 8.5
percent.
These calculations indicate that, even with higher discounting,
the Stern report’s estimates of future benefi ts and costs imply that
current mitigation passes a benefi t- cost test. Note that these calculations
rely on the Stern report’s projected time profi les for benefi ts
Global Warming
The Economists’ Voice, edited by Joseph E. Stiglitz, et al., Columbia University Press, 2011. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/deakin/detail.action?docID=3029387.
Created from deakin on 2017-07-03 21:10:08.
Copyright © 2011. Columbia University Press. All rights reserved.
Global Climate Change 21
and its estimate of annual costs. Much disagreement surrounds these
estimates, and further sensitivity analysis is called for. Still, I believe
there can be little serious argument over the importance of a policy
of avoiding major further increases in combustion by- products.
REFERENCES AND FURTHER READING
Stern, Nicholas. 2006. The Economics of Climate Change. http:// www .hm –
treasury .gov .uk/ Independent Reviews/ stern review economics climate change/ sternreview index .cfm .
The Economists’ Voice, edited by Joseph E. Stiglitz, et al., Columbia University Press, 2011. ProQuest Ebook Central,

Order Now

Description

Order Now