Economic theory was developed based on the first law of thermodynamics, which is conservation of energy and matter (Beinhocker 2006, 66–68). A basic assumption of economics is that when any source of material or energy becomes scarce, the price will increase which will cause new sources of material and energy to be developed. This assumption was reasonably valid in an earlier age when society was not perched on the edge of sustainability. Standard economic theory assumes an infinite amount of earth ecology to provide materials and energy, and to dispose of wastes (Beinhocker 2006, 68–74).
The central idea of economic theory is that supply and demand will create a fair price for goods and services used by the economy. The demand curve represents the fact that, as the price of a product decreases, consumers will buy more of that product. The cost or supply curve represents the fact that, as the price of the product increases, the producer has an incentive to produce more of the product.
The price of a product is determined by where the demand curve crosses the cost curve (Figure 7.1). The curve ignores where the materials and energy come from to make the product and where the waste products from making the product are disposed. This information is compressed into the cost of production. There is no direct way for economic theory to consider the environmental cost of the production. The curve also ignores time. It represents an instant in time. The way economic theory represents time in its calculations is through interest rates. A given quantity of money is worth more today than a year from now because the money could be invested and earn interest in a bank or a return on an investment. This is a correct and valid concept. However, from an environmental point of view the time value of money causes materials and energy to be more valuable used today, in a business venture, rather than being conserved for later use. This brings up the need to define various forms of sustainability.
FIGURE 7.1 Supply and demand curves determine optimum production.
Source: EPA 2010.
The strongest form of sustainability requires that natural capital; forests, rivers, oceans, and so on, be maintained into the future as a separate entity from human made capital. Forests provide oxygen, slow and filter storm water runoff, provide habitat for animals, moderate climate extremes, and, when sustainably harvested, supply wood for future generations. This stronger form of sustain ability calls for the actual service flows from the environment to be maintained over time, rather than the value of the service flows not declining (Wackernagel and Rees 1996, 37).
Most industries have a waste flow from their industrial processes. As an example, consider a paper mill located on a river. The waste stream can be dumped into the river at no cost to the paper producer. The waste stream will cause pollution in the river. The demand and cost curve diagram can illustrate the economics of the situation, by including a cost curve that includes the social costs of the pollution (Figure 7.2).
The method that society uses to modify this situation and enforce the social cost on the industry in question is to create regulations that control the amount of pollutant that can be dumped into the environment. The business environment generally resists regulations. They claim that it increases costs, and thus reduces competiveness and potential job growth. The question is, Why resist regulations if the costs can be passed on to the consumer in higher prices? Regulations that require a business to reduce its dumping of pollution into the environment incur an increase in their marginal cost. Demand for the product being produced generally does not change with the imposition of the new regulation. The result is that only part of the cost of the regulation can be passed on to the consumer. The remaining cost is borne by the business, which will reduce profits (Turner et al. 1993, 243).