Sustainability in Neo-Classical Economics - Coursework Example

Macro & Micro economics Introduction Neo classical economics is the theory of economics that deals with the optimization problem of the two most important agents in the economy; sellers and buyers. In simple words, the theory revolves around the concept of price mechanism followed in the free market economy and the market allocation of resources from within the opportunity sets (Endres 2002, 6). The sellers and buyers are on two sides of the market forces that meet at the market with the aim of maximizing private gains from obtaining goods and services (Weintraub 2002; Keita 1992, 7). This paper presents a study on the compatibility of this theory with the basic concepts of sustainability. The notion of sustainability relates to creation of economic and social conditions through activities of the present generation for their own existence and maintenance of these conditions in such way that the future generations are able to maintain their own existence (EPA 2013). The following section defines the basic concepts of sustainability and provides explanation of these concepts, which would allow an in depth understanding of the issue of compatibility of the neo classical theory of economics that has been studied in detail in the latter part of the paper. Concepts of sustainability ‘Sustainable development’ is a concept that has gained importance in the late 1990s. It encompasses a vast area of understanding of the path of development of the modern economies. However, in common understanding the ‘sustainable development’ or simply sustainability refers to the path of development for the current generation in these countries. It signifies the way in which the current generation utilizes the resources for satisfying its necessities without indulging in excessive consumption of the resources that the interest of the future generation is hampered. In 1987, the World Commission on Environment and Development implemented this notion in the political agenda of the Commission (Mulder and Bergh 2001). Since then politically the concept of sustainable development has become an important issue in the development process of the countries around the world. The world has experienced severely rising interest on the issue of sustainable development in the past two decades. Although it came into political light after the 1990s, economists have been devoting huge to the phenomenon of interaction between the ecology and the economy since the 18th century (Mulder and Bergh 2001). In this context, development means that the resources are utilized in conscious manner in the current period so that enough resources are preserved for the future generations for the fulfilling of their interests (Asheim 1994, 35). The purpose of taking such development initiative is to allow all generations to come to live a standard life. However, human activities involving the three interfaces; society, environment and economy creates a range of opportunities for the optimization of profit objectives of business organizations, but in most cases the core concept of sustainability is ignored while performing this pure economic optimization exercise. Neoclassical theory As already mentioned above, neoclassical economics is the theory of optimising ones utility by making economic choices. In most basic terms, utility is derived by consumption of a commodity if the commodity has such qualities that can satisfy some particular desire of the customer. This is also applicable to services (Jain, et al. 2007, 10). Individuals, that are part of the labour force of a country, own labour power. They offer labour power to the producers (firms) and are employed by them. The marginal value of the labour input incurs marginal profit for the producer. From the consumers’ side, the employees are themselves customers in the economy and the amount of wage received strikes a balance between the income earned by them and the opportunity cost of losing some amount of leisure due to working. The workers spend their income on goods and services by demanding them from the seller in the market and maximises their utility by balancing against the utility gained and the amount of sacrifice made in terms of money for obtaining the commodity or service. This describes the theory of demand for commodities from the neo classical approach. Producers either solve the cost minimisation exercise or the profit maximisation exercise while making production choices within the available set of resources. They produce commodity upto that unit at which the revenue generated by one extra unit (marginal unit) of commodity is exactly balanced by the cost of producing that unit (Weintraub 2002). On minimizing the cost of production or by maximising total revenue, firms maximize their profit. With this objective, firms hire labourers (labour resource) to the point at which wage rate is equalized by the marginal productivity of the labourer; i.e., the value addition made by the marginal labourer to total production (measured by marginal revenue) equals marginal cost of hiring that employee (measured by wage rate). This describes the neo classical theory of supply of factors of production to the producers and supply of goods and services to the free market. Economists have principally applied the neo-classical theory of economics as the standard theory to understand the importance of environmental problems form economic point of view. The neoclassical theory involves ‘economic agents’; such as, the firms and the households while making a cost-benefit analysis of the gains maximised on both sides, given the constraints (Soderbaum 2008, 19). In the neo classical theory, worth of a good or a service is determined by considering both the cost of production and the extent upto which the customer demands the commodity. In other words, price is the value of the relationship shared between the commodity and consumer preference for the commodity (Lipton, et al. 1998). In this framework the scarcity or level of availability of the commodity acts as the constraint. The neo classical economics stands on three founding assumptions. They have been described below. In this theory of economics considers individuals as the “primary unit of analysis” (Palan 2013, 118). Therefore individual choices are crucial in this framework. The society is made of individual buyers and sellers and social outcomes arrive from agglomeration of the preferences of these individual economic agents. Assumption of rationality is the other basic assumption of the theory; it is assumed that all the economic agents are rational and therefore all decisions made by them are outcomes of a successful optimization problem (maximization of the consumer surplus or the producer surplus). This assumption has a serious implication. It rules out the possibility of presence of individuals in the society who do not take consumption decisions on the basis of economic utility maximization. The final important assumption is that collective outcome in the economy is the most efficient and optimal result of economic choices. In the real economy, however, this assumption is often refuted since there are factors affecting the equilibrium results, such as, sharing of asymmetric information among the agents in the economy and capital goods influx in the manufacturing process that leads to technological advancement of the production process which creates more output at lower costs. The assumption merely presupposes that these outcomes are always at equilibrium (Palan 2013, 118). Neo classical economics and issue of sustainability The neo-classical way of interpreting the problem of environmental degradation has chiefly emphasized on the problem of resource allocation. The theory emphasizes on the welfare theory of economics, natural resource allocation, inter-temporal allocation of resources and refers to the problem of externalities and capital investment. Under neo-classical economics, environmental tribulations are referred to as mainly externality problems and disturbances in market equilibrium. However, this theory does not effectively address the issue of developing an efficient path leading to a sustainable economy (Mulder and Bergh 2001). The neo classical theory of economics acutely overlooks certain ecological concerns. The neo classical theory of economics revolves around the concept of maximizing the economic and commercial objectives of the economic agents (individual entity that on combining builds the society. However, the theory overlooks some important environmental concerns since it only considers the efficiency of market allocation of resources. The fact is ignored completely that firms and households are not only economic agents but also social agents. They do not take every minute decision with economic maximization of utility but also sometimes follow the principle of social objective maximization. Their necessities as social human beings lead them to make certain activities that create important impact on the biophysical environment. The neo classical cost-benefit analysis allows determination of economic values (prices) of goods and services, leading to determine the most desirable level of their production, but in this process the impact of these activities on the environment is underestimated (Alvey 1999). The benefits received from the environment are intangible and therefore measuring them in mathematical terms or evaluating their values in economic terms is difficult (Goodland and Ledec, 1987). Hence economists often ignore the sustainability issue that arise with these impacts on the environment (Kula 2013, 151). The debate on sustainable development strengthens when the outcome of a commercial project is compared and contrasted with the amount of inputs provided for the project to take shape. The Gross National Product (GNP) is normally considered an indicator of the level of a country’s economic development. Both the private sector and the government target at increasing production. This increases the GNP of the country, but simultaneously, the natural resource base is used with the objective of optimal allocation so that the maximum amount of output is produced at the minimum cost. From economic point of view, it is optimum utilization of resources leading to maximization of utility for consumers and profit for the firms; but resources are not used sustainably, such that they might be conserved for the future generations (Hueting, et al. 1998). Taking into consideration negative externalities, the actual utility level would be found to be much lower, which would adversely affect the long term development goals for the economy (Tietenberg and Lewis 2009, 26). Comparative advantage Most developing countries concentrate on production of agricultural crops. Comparative advantage for these countries in production of agricultural crops is higher that the industrialized nations due to the presence of various factors such as, cheap unskilled labour, free land and a long background of agriculture. Therefore, they are exporters of agricultural goods in the international market (Mukherjee 2002, 851). This economic activity is supported by the theory of comparative advantage (Maneschi 1998, 34). The theory of comparative advantage supports this economic activity on the ground that, if the country produces a commodity in lesser amounts, in which it enjoys less comparative advantage, it would be able to release more inputs for the production of the commodity in which it has more comparative advantage. It can therefore buy the other commodity from other countries (having more comparative advantage in its production) at a lower cost than the cost it would incur in producing it in its own country (Chacholiades 2006, 7). Hence the country would be able to buy the other commodities from the other countries that enjoy comparative advantage in the other commodities (Chacholiades 2006, 7). Figure: Sustainable yield (Source: Author’s creation) Such practices, as advocated by neo classical economists, lead to production of average sustainable yield (ASY) by exploiting the resource base optimally, thereby entailing huge costs to environment. However, this level of production corresponds to the total sustainable yield (TSY) curve on its falling portion. The marginal sustainable yield (MSY) is lesser than the average yield and the maximum MSY corresponds to zero TSY, implying that any greater marginal yield would ultimately cause a fall in total sustainable production. This shows that neo classical economics is not entirely compatible with the basic concept of sustainable development. Conclusion The discussion presented in this paper raises the debate on sustainable development by focusing on the issue of maximizing economic benefits by paying a higher long term and intangible price of environmental exploitation. Neo-classical economics is concerned with the effect of efficient resource allocation for achieving equilibrium in the market for goods and services. However, it does not account for the intangible detrimental effect cast by such allocation on the environment. These affects goes against the goal of sustainable development. Although firms are not responsible for resolving the macro problems of the society the economic arguments favouring their growth has to be made in such a way that they are capable of hindering unrestricted development at the cost of the environment (Hamilton 1999). References Alvey, James E. 1999. “A Short History of Economics as a Moral Science.” Journal of Markets & Morality 2 (1): 53-73. Asheim, Geir B. 1994. Sustainability. 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Van Den Bergh. 2001. “Evolutionary Economic Theories of Sustainable Development.” Growth and Change 32 (Winter 2001): 110-134. Palan, Ronen. 2013. Global Political Economy: Contemporary Theories. London: Taylor & Francis. Soderbaum, Peter. 2008. Understanding Sustainability Economics: Towards Pluralism in Economics. London: Routledge. Tietenberg, Tom and Lynne Lewis. 2009. Environmental Economics & Policy. New Jersey: Prentice Hall. Weintraub, E. Roy. 2002. Neoclassical Economics. Library of Economics and Liberty. http://www.econlib.org/library/Enc1/NeoclassicalEconomics.html . Read More