Inter-Linkage between Environment and Economy

 Economics is mainly concerned with allocating scarce resources. However, the market system works very poorly in allocating environmental resources. The linkage between the economy and the natural environment is very complex and multifaceted. Every economic action can have some impact on the environment, and every environmental change, in turn, can have an impact on the economy.

By ‘economy’ we refer to the entire set of economic agents (including firms and governments) and the interlinkages between the agents and the institutions such as the markets. The interaction between these economic agents is known as the economic system.

 By ‘environment’ we mean the biosphere (Earth) consisting of three domains i.e., 

• Atmosphere - Gaseous or Air

• Hydrosphere - Liquid or Water 

• Lithosphere - Solid or Land

The biosphere is made up of all living organisms as well as non-living organisms and the interaction between these two is known as ecosystem. 

Inter-linkage between Environment and Economy 

In economics, the environment is viewed as a composite asset that provides a variety of services. Specifically, the environment provides us the life support through three critical services viz. supply of raw materials for production and direct consumption, by acting as a sink in absorbing and transforming the economic wastes and providing amenities of aesthetic value to society.

1. Circular Flow/Material Balance

The interlinkage between the environment and the economy can be depicted by a Circular Flow diagram (also called the Material Balance Model) (Figure 2.1). For simplicity, we define the economy as broadly consisting of two sectors: production and consumption. The exchange of goods and services and factors of production are assumed to take place between these two sectors. Environmental services are primarily rendered through the three interlinked circles E1, E2, E3 and the all-encompassing boundary labelled as E4. 

Figure 2.1 Circular Flow Diagram 

 The production sector extracts energy resources (like crude oil, and coal) and material resources (like iron ore) from the environment. These are transformed into outputs of goods and services for consumption as well as for further production purposes. Along with these, there is recycling of resources within the production as well as the consumption sectors. Waste material arises at each stage of production as well consumption process. The production process creates waste in the form of industrial effluents, air pollution, water pollution and solid waste while consumption creates waste by generating sewage, litter and municipal refuse. 

 Thus, the environment’s first role is as a supplier of resources where it provides the economy with raw materials, which are then transformed into consumer products by the production process with energy fuelling the transformation. 

Its second role is as a sink or receptor for waste products. The natural environment functions as the ultimate repository of waste products generated in which gaseous substances like CO2 and SO2 go to the atmosphere, industrial and municipal sewage go into rivers and seas, solid waste goes to landfills, chloroform carbons go to the stratosphere and so on. 

The third role is to provide a wide range of aesthetic amenities of spiritual and educational value to the society (e.g. majestic mountainsthe, the serenity of the wilderness trek, adventure of the wildlife sanctuary, mesmerizing view of sunset in the sea) for which no substitutes exist. If we generate more waste, above the assimilative capacity of the environment, it will degrade this important function of the environment (e.g. polluted river detracting the amenity value of water flow in the environment). 

2. Laws of Thermodynamics 

Economy and Environment The interlinkages portrayed in the circular flow diagram (in Figure 2.1) are governed by the physical or natural laws called the ‘laws of thermodynamics’ – a branch of science concerned with the relations between ‘heat’ and ‘energy’. Both laws are held in a strictly closed system with no external inputs. It is grounded in the fact that ‘energy’ is the basic input on which any economic activity can sustain. 

The first law of thermodynamics, also known as the law of conservation of energy (or the material balance principle) states that ‘energy’ can neither be created nor destroyed i.e. it can only be transferred (or changed) from one form to another. 

 Hence, whatever we use up by way of resources must end up in some other form in the environmental system. For instance, coal consumption must be equal to the amount of ‘energy generated’ plus the waste in the form of gases and solids produced by coal combustion. 

 Boulding (1966) construed earth as a closed economic system where the economy and environment are characterised by a circular relationship. Hence, we cannot ignore the fact that a closed system sets limits (or boundaries) within which the task of achieving utility for human consumption needs to be considered. 

 The first law has thus two important implications in addition to conveying the significance of limits on matter (i.e. solid, liquid, gas) for supplying energy. 

One is that, as more matter is extracted by the production process, more waste is generated. Thus, economic growth which results in increased extraction of material resources (like coal, water, wind, etc.), for the generation of energy, is also accompanied by increased residual wastes.

Second, there are limits on the degree to which resources can be substituted for each other in production. The degree of substitutability that can be derived from the environment is a very important parameter referred to in the literature on economics as the ‘limits to growth’.

The second law of thermodynamics is known as the Entropy Law. The word Entropy refers in general to the ‘degree of disorder’, and in the context of energy generation for consumption, its ‘unavailability (once used) for new work’. 

Consider an example of a room cluttered with waste which reduces the utility of the room by its disorderliness. This can be restored only by cleaning up the room which in turn creates more accumulation of waste outside the room. Cleaning up the room makes it transform from a state of high entropy (disorder) to a state of low entropy (order).

Linking this to the production/consumption of energy in a closed system, which is inevitable and important for economic growth, the use of matter causes a one-way flow of energy i.e. from the low entropy resource to the high entropy resource (from order to disorder). 

 In a larger perspective, the material that is used in the economy tends to be used entropically i.e. the residual gets generated and dissipated within the economic system. About the energy process, this law implies that no conversion of energy, from one form to another, is completely efficient and the conversion process is irreversible. Some energy is lost (i.e. used up) in conversion and the rest once used is no longer available.

 For example, consider a discarded car. Out of the many hundreds of components of the car, it is possible to recycle only a few (e.g. aluminium, steel, lead) with a major part not technologically feasible to recycle. In the same way, the carbon dioxide released in the burning process does not create another useful substance.

 Entropy therefore creates a physical obstacle. Thus, if the earth is a closed system, with a limited stock of low entropy energy resources (fossil fuel), then the system is unsustainable if the economic activity degrades the energy resources beyond a point (referred to as the ‘limit to growth’) where no potential for its further use remains.

 Although the earth is not a closed system, since we obtain energy directly from the sun too, we have a limited capacity of other energy resources to utilise. Thus, entropy law suggests that the flow of solar energy establishes an upper limit on the flow of energy that can be sustained. Once the stock of stored energy (such as fossil fuel and nuclear energy) is exhausted, the amount of energy available for useful work will be determined solely by the flow of solar energy and further by the amount that can be stored. In other words, over the very long run, the growth process will be limited by the availability of solar energy and our ability to store and use it.

3. Life Support System and Sustainability 

Thus, the natural environment is a very special asset, since it provides a life support system that sustains our very existence. The three economic functions i.e. 

(i) resource supply;

(ii) waste assimilation; and 

(iii) amenity and aesthetic value can be regarded as components of one general function of the natural environment i.e. the function of life support. 

The environment also provides services directly to the consumers (e.g. the air we breathe, the nourishment we receive from food and drink, and the protection we derive from shelter and clothing) which are all benefits we derive directly or indirectly from the environment. 

The problem we face with the economic designs or systems – whether free, planned, or mixed – offers no guarantee that the life support functions of the natural environment will continue to last undisturbed. The working of the economic system, under any set-up, risks the running down, depreciation and depletion of the natural environment’s functions. 

 We, thus, do not have an ‘existence theorem’ that relates the scale and configuration of an economy to the set of environment-economy interrelationships underlying the economy. But if we are interested in sustaining an economy, it is important to establish the sustainability conditions for the compatibility of economies and their environments.

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