New Directions in Development Economics and Climate Change

October 14, 2008

Research Article

Aneel Salman

Two of the most pressing issues of our time are global climate change and the increasing income gap between the rich and the poor. Both of these issues are particularly acute in Pakistan with its unique and fragile environment and its rich and varied cultural and economic traditions. Dealing with these problems requires innovative approaches based on sound economic analysis and a detailed knowledge of the specific environmental and social conditions at work on the ground.

According to many observers, the micro foundations approach to economic theory has been in a state of crisis for some time now due to theoretical intractabilities within the Walrasian framework and empirical falsification of some of its basic assumptions regarding consumer and firm behavior1. (for surveys see Bowles and Gintis, 2000; Gowdy and Mayumi, 2001; Gowdy, 2004; O’Hara and Stagl, 2002). The importance of the debate within economics was highlighted in the Presidential Address to the 2007 American Economic Association in Chicago given by Nobel laureate George Akerlof who lamented the lack of correspondence between predictions made by macroeconomic models based on the “rational actor” model and actual human behavior: “If there is a difference between real behavior and behavior derived from abstract preferences, New Classical economics has no way to pick up those preferences.” 2 He called for a redirection of economics based on norms of observed human behavior and the detailed workings of actual markets. Akerlof’s advice is relevant to the quest to achieve a workable economic program to deal with economic development in the face of global climate change. Related development issues are gender inequality and the growing gap between the rich and the poor.

New Directions in Development Economics

In addition to the changing realities of economic development, the issue of global climate change has also forced economists to re-think basic assumptions embedded in the traditional economic framework. For example, Dasgupta writes: “Climate change and biodiversity losses are two phenomena that are probably not amenable to formal, quantitative economic analysis. We economists should not have pressed for what I believe is misplaced concreteness.” 3 Likewise, Weitzman in a commentary on the Stern Review writes: “But in lumping together objective and subjective uncertainties and thereby obscuring their distinction… I think that contemporary macroeconomics goes too far and leads to a mindset that too easily identifies probability (and “economic science”) with exercise in calibration to sample frequencies from past data.” 4 Although he does not use the term, Weitzman calls for applying the “precautionary principle” to avoid the potentially catastrophic effects of global climate change. This change of attitude among economists who have written extensively about climate has important policy implications. And, although directed towards climate change models, the remarks of Dasgupta and Weitzman could easily be applied to many formal models of economic development.

Economic Models of Climate Change

The most widely used economic models of climate change are integrated assessment models linking climate and economic simulations 5 (Nordhaus and Yang, 1996; Stern, 2007). These models start with the standard economic assumptions of rational actors, perfect competition, and optimizing behavior. We do not intend to go into a detailed critique of these optimizing-based climate change models (for this see Laitner, DeCanio, and Peters, 2001; Spash, 2002; van den Bergh, 2004) 6. The debate concerning the Stern review has uncovered the fact that the differences among the major climate change models are driven almost solely by assumptions about the rate of discounting the benefits of climate change mitigation (avoiding the costs of future climate damage to economic activity) and costs of mitigation efforts. 7 The standard formula used in these models is based on the work of Ramsey (1928), Arrow (1966) and Fellner (1967) 8 , among others:

1) r = Δ + η * g

Where r is the discount rate, Δ is the rate of pure time preference, η is the elasticity of substitution for consumption, and g is the growth rate of per capita consumption. The “inherent discount rate” Δ is the part of the discount rate arising solely from myopia or impatience (Spash, 2007) 9 . η reflects the extent to which marginal utility changes as income changes in the future. As the many critics of the Stern report have pointed out, the results of the report’s modeling exercises are driven by (ultimately) arbitrary assumptions about the components of the discounting equation (1)—the rate of time preference, the marginal elasticity of consumption, and estimates of future consumption growth rates. There is no consensus on how to assign values to any of these numbers. In the case of climate change, we are dealing with pure uncertainty in terms of the potential risks, the prospects for future economic growth, and the “proper” social discount rate (Weitzman, 2007). As a result of the debate about economic modeling in the Stern report, the bad news is that there is consensus among economists that the standard economic model is of limited use in dealing with either mitigation or adaptation policy responses to climate change. But the good news is that the door is open for a realistic approach to deal with climate change that combines sound science and contemporary approaches to economic theory and policy. A positive outcome of the Stern Review debate is that it forced economists to recognize the ethical content of seemingly “positive” economic analysis. Another positive outcome of the climate change debate is the realization that the policy recommendations of climate change specialists echo the recommendations of development economists 10 (Kramer, 2007). In terms of social risk management, climate change adaptation policies represent “no regret” policies in the sense that they are desirable with or without climate change 11 (Heltberg et al, 2008).

Climate Change in Pakistan

A consensus has emerged among scientists and policy makers that global climate change represents a major threat to the environment and to the well-being of humankind and the biosphere 12 (Stern, 2007; IPCC, 2007). During the past century, average global temperature has risen by about 1°C with much of that increase due to human activity, especially fossil fuel burning and deforestation. The rate of increase has accelerated during the past 20 years or so as the human impact now dominates natural processes. Global temperatures are projected to increase further by 1.4 °C to 5.8 °C by 2100 and to continue to rise long after that (IPCC, 2007). Scenarios of the likely consequences of such an increase differ substantiallyamong regions but include sea level rise, shortages of fresh water, increased droughts and floods, more frequent and intense forest fires, more intense storms, more extreme heat episodes, agricultural disruption, the spread of infectious diseases, and biodiversity loss.

South Asia is particularly vulnerable to the effects of climate change. A substantial portion of the world’s population lives in the four countries of Pakistan, Nepal, India and Bangladesh. Millions of people in India, Pakistan, and Bangladesh will eventually be displaced by rising sea levels. The drinking water for much of India and Pakistan comes from the Himalayan, Karakoram, and HinduKush glaciers that are melting rapidly from warmer temperatures 13 (Jianchu et al., 2007). South Asian economies are heavily dependent on agriculture – the economic sector most vulnerable to climate change. Crop yields are already declining in the region, probably due to climate change. Also changes in the timing of monsoons are having an adverse effect.

The impact of climate change on Pakistan is likely to be severe. Climate change and environmental disruption, and the social disruption that is likely to accompany it, will probably have a negative impact on human development indicators. Sixty-five percent of Pakistan’s population, and two-thirds of its poor, live in rural areas. These are the areas that will be most affected by climate change and will also be the most difficult to assess, plan for, and administer. Agricultural employment and income will likely be disrupted. Those with inadequate incomes will be most vulnerable to sea level rise, water shortages, and the intensification of storms. In the decades to come much of the coastal areas of Pakistan will be submerged, water shortages will result from disappearing glaciers, and agricultural production will almost certainly be disrupted. These changes could lead to political instability, security concerns, and conflicts with neighboring countries. There is already a growing gap between rich and poor in Pakistan and climate change is likely to make this gap larger unless pre-emptive steps are taken. But how does a developing country like Pakistan cope with anticipated changes that are generally known but only vaguely understood in terms of timing and severity? One way to begin is to consider the basic human needs of the local people, and how the provision of these basic needs will be affected by climate change.

“Climate change adaptation will depend critically on cooperation among
countries, regions and individuals. Policies building on types of behavior
conducive to cooperation, placing less emphasis on material possessions,
and recognizing the necessity of shared sacrifice, are more likely to be
successful in meeting the climate change challenge”

 Innovative Approaches to Climate Change and Development Policies

The effects of climate change will be felt first and foremost at the household level. In Pakistan, meeting this challenge will require a variety of policy approaches including technological innovations, empowering local communities with the tools and information they need to adapt, and setting up mechanisms to provide relief from the effects of climate change. Adapting to climate change is increasingly challenging and will become more and more difficult as global temperatures rise. The task will be made easier because of new directions in economic theory and policy recommendations recognizing the heterogeneity of regional economies and of human communities. Two new directions in economics are relevant to this task.

Sustainable Well-Being

Traditional economic theory and development policy equates human welfare with per capita income 14 (Gowdy and Salman 2008). Frey and Stutzer (2002) point out that economic text do not even discuss the meaning of human welfare but merely assume that welfare is equivalent to income and that higher income makes a person happier. 15 In contrast to the traditional approach, a growing body of economic research uses measures of subjective well-being as indicators of social welfare 16 (Kahneman and Sugden, 2005. These measures show that per capita income growth and increases in well-being is frequently only weakly correlated in real-world contexts, at least above some minimal income level (Frey and Stutzer, 2002). Focusing only on income misses some equally important contributors to well-being. John Holdren (2008) in his 2007 presidential address to the American Association for the Advancement of Science outlined the three pillars of sustainable well-being (1) economic conditions and processes, (2) sociopolitical conditions and processes, and (3) environmental conditions and processes. 17

Behavioral Economics

Another focus of contemporary economics beginning to influence pubic policy is what is variously called experimental economics, behavioral economics and evolutionary game theory. Experimental results from these related areas have firmly established that human choice is a social, not self-regarding, phenomenon. Two broad principles have emerged from the literature (1) human decisionmaking cannot be accurately predicted without reference to social context and (2) regular patterns of human behavior, including responses to rewards and punishments, can be predicted both within particular cultures and across cultures 18 (Gowdy, 2008). Among the identified regularities in human behavior and their policy implications are (1) the presence of altruism and cooperation in human societies, (2) altruistic punishment to eliminate free riding, promotion of cooperation, (3) the contribution of the natural environment to human well being, and (4) loss aversion and regret avoidance, among others. These regularities are beginning to be successfully applied to policy design 19 (Duflo et al. 2005).

Climate change adaptation will depend critically on cooperation among countries regions and individuals. Behavioral science has shown that competition and material accumulation are only one part of the richness of human behavioral patterns. Policies building on types of behavior conducive to cooperation, placing less emphasis on material possessions, and recognizing the necessity of shared sacrifice, are more likely to be successful in meeting the climate change challenge. It is this evolutionary heritage that holds promise for more humane development policies and for meeting the unprecedented challenges humankind will face in the coming decades.

* Author’s Note: This is a short summary of a paper presented by Dr. John Gowdy, Professor Humanities and Social Science. Rensselaer University and President of International Ecological Economics, at the PIDE Conference, March 12-14, 2008, in Islamabad


End Notes 1 Bowles, S. and Gintis, H. 2000. Walrasian economics in retrospect. Quarterly Journal of Economics 115, 1411-1439. Gowdy, J. 2004. The revolution in welfare economics and its implications for environmental valuation and policy. Land Economics 80, 239-257. Gowdy, J. and Mayumi, K. 2001. Reformulating the foundations of consumer choice theory and environmental valuation. Ecological Economics 39, 223-237. O’Hara, S. and Stagl, S. 2002. Endogenous preferences and sustainable development. Journal of Socio-Economics 31, 511-527.

2 Akerlof, G. 2007. The missing motivation in macroeconomics. American Economic Review 97, 5-36.

3 Dasgupta, P., 2007. Climate-change challenge for the poor – Part I. YaleGlobal online. Dasgupta, P. 2007. Discounting climate change. Review of Environmental Economics and Policy, forthcoming.

4 Weitzman, M. 2007. A review of the Stern Review on the Economics of Climate Change. Journal of Economic Literature XLV, 703-724.

5 Nordhaus, W. and Yang, Z. 1996. A regional dynamic general equilibrium model of alternative climate-change strategies. American Economic Review 86, 741-765. Stern, N. et al. 2007. The Economics of Climate Change: The Stern Review. Cambridge, UK: Cambridge University Press.

6 Laitner, J., DeCanio, S., and Peters, I. 2001. Incorporating behavioral, social, and organizational phenomena in the assessment of climate change mitigation options. In: Jochem, E. at al. (Eds.), Society, Behavior, and Climate Change Mitigation. Dordrecht: Kluwer. Spash, C. 2002. Greenhouse Economics. , London and New York: Routledge. van den Bergh. 2004. Optimal climate policy is a utopia: from quantitative to qualitative cost-benefit analysis. Ecological Economics 48, 385-393.

7 The Stern Review used a standard model (PAGE2002) to forecast the economic costs and benefits of climate change. But the report also argued forcefully for considering the importance of ethics, and the responsibility to future generations and the rest of the earth’s biosphere, in the climate change debate.

8 Ramsey, F. 1928. A mathematical theory of saving. Economic Journal 138, 543-59 Arrow, K. 1966. Discounting and public investment criteria. In A.V. Kneese and S. C. Smith, eds. Water Research, 13-32, Baltimore: Resources for the Future and Johns Hopkins University. Fellner, W. 1967. Operational utility: The theoretical background and measurement. In Ten Economics Studies in the Tradition of Irving Fisher, 39-74, New York: John Wiley & Sons.

9 Spash, C. 2007. The economics of climate change a la Stern: Novel and nuanced or rhetorically restricted? Ecological Economics 63, 690-700.

10 Kramer, A. 2007. Adaptation to Climate Change in Poverty Reduction Strategies. United Nations Development Program, Human Development Report Office, Occasional Paper 34, Geneva.

11 Heltberg, R., Jorgensen, S., and Siegel, P. 2008. Climate Change, Human Vulnerability, and Social Risk Management. The Social Development Department, Washington, D.C.: The World Bank

12 Intergovernmental Panel on Climate Change. 2007. Climate Change 2007: The Physical Science Basis. Contribution of working group I to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change, Geneva, Switzerland. Available at

13 Jianchu, X., Shrestha, A.,Vaidya, R., Eriksson, M., and Hewitt, K. 2007. The Melting Himalayas: Regional Challenges and Local Impacts of Climate Change on Mountain Ecosystems and Livelihoods. International Centre for Integrated Mountain Development (ICIMOD) Kathmandu, Nepal.

14 Gowdy, J. and Salman, A. 2008. Climate change and economic development: A pragmatic approach. Keynote Address, Pakistan Society of Development Economics, Islamabad, Pakistan

15 Frey, B. and Stutzer, A. 2002. Happiness and Economics: How the Economy and Institutions Affect Well-Being. Princeton: Princeton University Press.

16 Kahneman, D., and Sugden, R. 2005. Experienced utility as a standard of policy evaluation. Environmental and Resource Economics 32, 161-181.

17 Holdren, John. 2008. Science and technology for sustainable well-being. Science 319, 424-434

18 Gowdy, J. 2008. Behavioral economics and climate change policy. Journal of Economic Behavior and Organization (in press)

19 Duflo, E., Kremer, M., and Robinson, J., 2005. Understanding technology adoption: Fertilizer in Western Kenya, preliminary results from field experiments. Working paper MIT.