Explain Formally The Environmental Kuznets Curve Hypothesis Economics Essay

Clearly as countries strive for increased growth they attempt to produce greater output and logic dictates that with greater output, ceteris paribus, there must be greater input and thus a depletion of resources from our environment. Simultaneously greater output leads to greater levels of emissions and waste, thus the carrying capacity of the biosphere will be exceeded sooner. Simon Kuznets’s Environmental Kuznets Curve hypothesis states that ‘economic inequality initially increases, reaches a critical threshold, and then decreases as the country “develops”‘ (Economic Growth and Income Inequality, 1955). The hypothesis is shown by Figure 1 below.

http://upload.wikimedia.org/wikipedia/commons/6/6b/Kuznets_curve.png

Figure

It is important to realise the relationship of the EKC shows a correlation between environmental equality and income, not causation. This simply means that a trend has been realised between income and economic inequality which states that initially as income rises so does inequality, however at a certain threshold inequality begins to diminish, and the reason for this change is not immediately apparent.

The concept that environmental equality is influenced by economic growth originated from earlier economic theory, as in many 1970s theoretical literature on pollution and growth, optimal pollution control models have ‘inverted U curves’ of pollution implicitly embedded in them (Selden, 1994).

There are two main economic explanations for the Kuznets Curve hypothesis. Firstly the environment can be viewed as a luxury good. This means that although initially individuals are not willing to trade consumption for environmental investment, at a certain level of income individuals begin to increase their expenditure on the environment to enjoy its benefits. It can therefore be argued that economic development is a means to environmental improvement and thus whilst initially the environment will suffer from growth, it will benefit from the economic prosperity in the long run.

Secondly as countries experience growth and income increases there are recognised historical structural development stages to the country’s economy much like, as Roslow noted, the moving from traditional to industrial economies and then to a mature mass consumption economy (The Stages of Economic Growth, 1960). For example, in a Less Developed Country (LDC), a structural transformation from primitive agriculture, through manufacturing and into services would initially utilise the environment efficiently through agricultural trade, with greater income this might transform into manufacturing which is highly dependent on environmental resources and also carries large negative externalities such as pollution. However once again, with further growth industry and trade will move towards services which have the least impact on the environment. The study by Syrquin in 1989 econometrically ties structural changes to economic growth and is often used to discuss the EKC hypothesis (Grossman, et al., 1995). It is obvious to conclude that if these developmental stages occur and the transitions between the stages correlate with specific per capita income levels, then a relationship where pollution levels initially rise before subsequently falling, as average incomes increase. Unrah and Moomaw argue that we cannot be sure whether the ‘stages of economic growth’ are a deterministic process that all countries must pass through, or simply a description of the development history of a specific group of countries during the 19th and 20th centuries that may never again take place (An alternative analysis of apparent EKC-type transitions, 1998).

We can look at the turning point in the EKC from increasing environmental inequality to diminishing environmental inequality as a change of individual interest from self-interest to social interest. However Arrow (2000) points out that the EKC provides very little information about the mechanisms by which economic growth affects the environment. For example, as income increases industry developments and innovations may have reduced negative externalities on the environment. Also with greater national income and wealth there is greater demand on the authorities for environmental regulations.

There have been several empirical and analytical studies of the EKC hypothesis and whilst some support the conclusions of Kuznets others counter his findings. There is however, little debate that many pollution emissions in the developed countries of the Organisation for Economic Co-operation and Development (OECD) have stabilised or indeed declined over recent years whilst these same countries per capital incomes have simultaneously increased (An alternative analysis of apparent EKC-type transitions, 1998).

Unrah and Moomaw demonstrate in their 1998 empirical study of France GDP growth against CO2 levels an ‘inverted U-shaped curve’ is produced which supports Kuznets hypothesis (An alternative analysis of apparent EKC-type transitions, 1998).

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Figure – France CO2 vs GDP 1950-1992

Grossman and Krueger in 1994 produced a study with an “N-shaped” curve where after a high enough threshold there were increases in environmental degradation. Grossman also in 1994 found that the turning point is sooner for an obvious short term environmental hazard for the local population (Grossman, et al., 1995). Arrow in 1995 stated that responsiveness is not immediate so income growth does not spontaneously bring a reduction to environmental degradation. As such Arrow concludes that while short term indicators would support Kuznets’s hypothesis, long term indicators would not.

The huge potential for economic growth through effective utilisation of the environment has made efficient and socially desirable management of environment resources is a key issue within economics. The environment surrounding each individual economy has always been fundamental to the performance of economic growth. Along with creating economic prosperity the environment also performs the essential function of supporting life and thus managed with care and responsibility. As has been seen through history, exploitation of the environment which has provided crucial economic inputs may also be the instrument which impairs the earth’s ability to support life. For example, in last decade we have seen the emergence of concern about how economic expansion of the world economy is leading to irreparable global damage (Silbert, 2009). As such decisions regarding the environmental trade-off between economic growth and preservation require careful consideration from political authorities.

Kuznets EKC Hypothesis EKC Analysis Conclusions

One policy proposed by economists is to allow countries to economically grow out of environmentally damaging activity. Looking at countries with already large economies, we see signs of environmental regulation such as emissions standards, extensive recycling programs, and limited timber harvesting. The economists supporting a policy that initially allows for environmental degradation assert that if a country can achieve sufficient economic growth in a short period of time then perhaps environmental damage should be tolerated.

A well-known hypothesis providing support for a policy that emphasizes economic growth at the expense of environmental protection is the environmental Kuznets curve (EKC) hypothesis. It posits that countries in the development process will see their levels of environmental degradation increase until some income threshold is met and then afterwards decrease. If true, economic policies should allow extensive, although not necessarily absolute, use of the environment for growth purposes. But carrying out such policies involves inherent dangers.

If developing countries decide to overlook environmental protection by counting on rising incomes to abate environmental damage the consequences could be devastating. The most pressing danger is that additional environmental degradation could cause some irreversible and significant harm. This could occur before the predicted income threshold is met. The other concern with counting on incomes to reduce environmental damage is that the EKC hypothesis could easily be incorrect and relying on its predictions would lead to consistently insufficient protection.

This paper evaluates the validity of the EKC hypothesis and argues that it is not a sound basis for policy formation and justification with so much at stake. The plan of the paper is as follows. Section II examines the basis for the EKC hypothesis and conditions under which it may accurately predict a country’s future environmental status. Section III briefly summarizes empirical studies investigating EKCs and looks at the findings of these studies. Section IV identifies the inherent dangers in determining environmental policy based upon the EKC hypothesis. Some concerns are relevant if the hypothesis does not hold and others are present even if it proves a correct forecaster of environmental quality. Section V concludes with my assessment of how well the hypothesis works as a justification for dubious environmental policies.

Section II: The Concept of the Environmental Kuznets Curve

The EKC hypothesis asserts that countries will naturally move from relatively low environmentally degrading activity to highly degrading activity and then, once a certain income threshold is achieved, will proceed to less degrading activity once again. This assertion allows one to predict the relative level of environmental damage being caused by a country by looking at GDP per capita. However, this prediction is relative to individual countries. In other words, each country has its own EKC, based upon resource endowment, social customs, etc., from which it progresses along relative to its GDP. A graphical model of the hypothesis helps illustrate the inverted “U” shape of the relationship:

Environmental Damage

Y*

Income per capita

The y-axis represents the amount of environmental damage due to economic activity and the x-axis represents income per capita. Y* represents the threshold income, sometimes referred to as the “turning point”. That point signifies the income level at which environmental damage per capita begins to recede.

It is important to note that the theoretical EKC graph does not explicitly express time as a dimension and for this reason the use of the EKC hypothesis to justify policy decision – an action that by definition incorporates time – would appear inadequate. Only by comparing two different countries can the inverted “U” shaped curve be derived as seen above. However each country possesses its own unique EKC and therefore each country’s policies should be organized accordingly. In order for the graph to show an EKC, and thereby be valid as policy justification, we must incorporate a time dimension. We find a time dimension along the x-axis. The EKC hypothesis assumes that changes in income per capita only occur over time. By including this supposition of changes in income inherently signifying time, the graph can now show an EKC for a specific country. The identification of a country’s particular EKC provides a basis for using it to influence policy. Possessing the theoretical model by which the EKC hypothesis is used for economic policy we turn our focus to explaining why the inverted “U” shape exists.

There are two primary explanations for the proposed shape of the EKC. The first examines the history of developed countries and the paths they took to achieve development. The second reflects the changing preference for environmental quality as incomes rise.

Historically, all developed countries’ economies were originally based upon agriculture, a state that produced little environmental damage. Their economies later switched to a much more environmentally damaging state that focused on industry and manufacturing. Finally, upon switching from heavy industry to the now-prevalent service-based economies the levels of environmentally damage fell in most developed countries. Two main factors lead to environmental damage that occurrs during industrialization. First, the harmful by-products of production damage the environment. High levels of pollution and water contamination accompany the expansion of industry. The second factor is the increased consumption of natural resources. The extensive over-use of land, deforestation and mining of mountains is a form of environmental damage in and of itself. A common conclusion of this development pattern is that LDCs must pass through the same phases in order to achieve economic growth. Furthermore, if forced to adhere to strict environmental regulations, LDCs will be at an economic disadvantage compared to the already developed countries. Many LDCs point to this competitive disadvantage when rejecting global environmental standards. The next stage of development saw industrial nations switching to service-based economies, a trend that all global GDP leaders tend towards. During this phase the income threshold of for the EKCs for certain substances appear to have been reached. Service-based economies are able to avoid many of the most environmentally damaging economic activities. Also, highly resource-dependant production is cut significantly which reduces the impacts of resource input and harmful emissions.

The graph reflects the switch from an industrial to service-based economy somewhere around point Y*. The decreasing industrial production decreases the environmental damage despite the rising GDP associated with the service sector economy.

Environmental impacts also fall as a result of improved technology discovered in developed countries. In some cases technology leads to a more efficient use of inputs. Other technological advancements make it possible to restrict the harmful effects that economic activity have on the environment.

The second reason that a high-income level can reduce environmental damage is by altering the demand for environmental quality. Known as the “income effect”, sufficiently high GDP per capita often leads individuals to place environmental quality above additional economic growth. The aggregation of these individual preferences plays an integral role in determining the income threshold.

The EKC income threshold aggregates all environmentally damaging agents into a single numerical value. However, taken individually economists can place dollar values on the turning points of damaging agents. For example, in a 1997 paper by Cole, Rayner and Bates, the authors found the turning point of CO and NO2 emissions to be around $9,900 and $14,700, respectively. Using environmental quality preference as an explanation, the income threshold represents the income level per capita at which the preference for environmental quality outweighs the preference for additional income. This change in preference occurs on a public level, rather than a private one. Microeconomic decisions to support more environmentally friendly goods and services cannot account for the income effect. The issue is instead a matter of public policy. The changes in environmental standards reflect political pressure on the federal government and state governments. Effective lobbyists have altered the political and social landscape to favour one of increased environmental quality.

Despite the ‘clean’ nature of high-income countries it remains difficult for EKC supporters to explain certain things – such as the fact that the United States is, by far, the world’s largest greenhouse gas emitter. Defenders of the EKC hypothesis say this is due to the incredibly large economy of the U.S. and that the seemingly large figures are, proportionate to GDP, not as astonishing as they appear. The only other defense to the greenhouse gas emission statistic is that the income threshold may not have been reached.

According to the EKC hypothesis, changes to evolving economies and the individual preference for environmental quality combine to determine the income threshold. However, whether or not an inverted “U” shaped curve exists at all is still up for debate.

Section III: Evidence For and Against the EKC Hypothesis

Evidence regarding the EKC hypothesis is circumstantial and inconclusive. Most early studies that supported the hypothesis focused on a single damaging agent, such as a pollutant. Identifying key characteristics associated with agents that have been studied we find that only certain types of agents exhibit an EKC.

Evidence supporting the EKC first began in 1994 when Selden and Song found an EKC for SO2 (Environmental quality and development: Is there a Kuznets curve for air pollution emissions?, 1994). A later test in 1995 by economists Grossman also found SO2 emissions to follow an EKC (Grossman, et al., 1995). They found a turning point between $4,000 and $6,000. Another early documentation of EKC support came from Theodore Panayotou who found the turning point of deforestation to be $823.

After the initial studies, other economists began to investigate the validity of the EKC hypothesis and found refuting evidence. In the 1997 paper by Cole, Rayner and Bates, they found no EKC for traffic, nitrates or methane. A different study in 1997 by Horvath examined energy use and found no EKC; rather, energy use per capita rose steadily with increased income.

Evidence appears to support the EKC hypothesis only for a limited type of damaging agents. The emission SO2 is found in urban waste areas and is thereby characterized by its locality. Deforestation also reflects a situation involving a specific location. Damaging agents that affect only a particular site tend to show EKCs. However, a damaging agent such as traffic is plain to see and also affects certain areas heavily. In this case the agent is dominated by a scale effect – increased activity leads to increased environmental impact. While traffic-related pollution is generally iterated by population size, damaging agents such as energy production by-products increase with GDP per capita.

Section IV: Dangers of the EKC Hypothesis as Policy Justification

There exist many dangers in allowing an economy to simply grow out of environmentally damaging activity. Some of these dangers arise because the EKC hypothesis does not hold true in all cases. Others exist even if we assume the hypothesis as an accurate predictor of environmental conditions.

The following is a list of concerns regarding the EKC hypothesis:

(I) It remains inconclusive if most damaging agents follow the EKC.

(II) The threshold income may be irrelevantly high or the temporary period of increasing environmental damage too long.

(III) The decrease in environmental damage seen in developed countries may reflect the production of “dirty” products abroad and subsequent importation.

(IV) The “absorptive capacity” of our earth is unknown.

(V) EKCs may only exist in certain political atmospheres.

A detailed examination of the above concerns illustrates the inherent dangers in accepting the EKC hypothesis and afterwards using it to justify policy.

As discussed above, only local and regional damaging agents show signs of EKCs. Other “difficult to detect” agents may simply increase with GDP per capita. This discovery leaves open to question whether more agents than not respond to income increases. If there exist more agents that do not respond then attempting to grow past these impacts would be impossible.

Many damaging agents may respond to income levels, but not until GDP per capita approaches out-of-reach levels. If in a developed country, the turning point for a damaging agent is above, say, $50,000 then neglecting to react will create damage for a considerable amount of time. Over the time it takes to achieve the turning point, the environmental damage may prove more costly than it’s worth. Obviously, in an LDC the turning point value needs only to be considerably lower and still have the same adverse effects. It is important to note that it is unclear if forgoing the opportunity for economic growth may is the right or wrong decision. Nonetheless, using solely the EKC hypothesis to justify this action remains unwise, as the outcome is not known.

Another consideration that challenges the EKC evidence is that wealthy countries may be importing “dirty” products, thereby contributing to environmental degradation; the only difference is that the degradation is not domestic. The first hypothesis to bring up this possibility was the Pollution Haven hypothesis. It states that developed countries export their dirty industries to LDCs whose governments have more lax environmental standards. Many economists discounted this hypothesis with strong evidence showing that capital flows do not follow environmental regulations. However, this does not exclude the possibility of dirty industries existing in LDCs and coincidently exporting their products to wealthy countries. In this case, wealthy countries only started along the downward slope on the EKC by domestically reducing environmental damage. When taken globally their increased consumption due to income may still be increasingly damaging.

Another danger is that leaving the quality of our environment subject to economic activity, even for only a short period, may be disastrous. The ability of the earth to absorb the damaging agents produced by economic activity, called “absorptive capacity,” is not yet known. A good example is global warming. More and more studies confirm that rising global temperatures are due at least in part to human activity. Predictions regarding the consequences of this change are still being debated. But further activity could push the environment’s limits to a point that causes serious repercussions for humanity.

A final concern is that even if developing countries can achieve high levels of income per capita they may not possess a political atmosphere conducive to environmental protection. Assuming that the aggregate turning point is in a country reached, that country it is not necessarily going enact protection. Countries that possess sufficient demand for environmental quality still only achieve it with policy revisions. The most successful avenues for obtaining environmental quality are lobbyists. Without a government that responds to political pressure by these public groups there is no reason to believe that its policies will reflect the demand for a cleaner environment. In addition to this point, it also remains to be seen if all cultures place similar values on environmental quality. While constituents of currently developed countries may desire protection, countries in the process of developing may reach a point of equivalent income and still not demand environmental quality. Conversely, they may actually demand protection earlier.

Section V: Conclusion

The questions and concerns about the EKC hypothesis that I have examined in this paper raise significant doubt as to the wisdom of adopting environmental policy based upon the EKC hypothesis. Even assuming its validity, the EKC hypothesis generates considerable doubt as to its effectiveness at balancing economic growth with environmental protection. Given these doubts policies must be, at most, based only partially on predictions by the EKC hypothesis.

The correct balance between environmental protection and economic growth continues to be debated. Both of the opposing views present important arguments. Obviously, having either extreme – either unhindered economic activity or overly protective environmental measures – is an inadequate solution. The largest problem facing the debate is the lack of knowledge regarding the degree of robustness present in our earth’s environment. Still unclear of its ability to offer its resources and to soak up our by-products, our only course of action is to, with both needs in mind, tread carefully.