Nafziger Economic Development (4th ed)

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The Organization of Petroleum Exporting Countries (OPEC) is a cartel whose members agree to limit output and fix prices. Although founded in 1960, OPEC achieved its major success through concerted action to increase oil prices in 1973 and 1974. During the 1970s, OPEC countries took over ownership of the oil concessions within their territories, and international oil companies became a combination of contractor and sales agent for these countries.

However, during the 1980s and early 1990s, conservation, the development of alternative energy sources, and a recession among much of the high-income Organization for Economic Cooperation and Development (OECD) – the United States, Canada, Western Europe, Japan, Australia, and New Zealand – dampened the growth of oil demand.2 At the same time, the income and commodity terms of trade of oilexporting LDCs fell, increasing the external debt they owed DCs, their banks, the IMF, and the World Bank and the policy leverage of these institutions, contributing to pressures for OPEC liberalizing and providing improved terms for foreign oil producers. Meanwhile OPEC, with only 78 percent of production in 2002, was finding it more difficult to enforce prices and quotas, as members, such as Iran and Nigeria, that faced mounting debt, political, or military problems, exceeded their quotas or offered discounts below posted prices, and major nonmember producers, such as Russia, China, Mexico, and Norway, increased their production shares.

Saudi Arabia (population 21.4 million), with 25 percent of the world’s estimated reserves (Table 13-1) and the lowest cost production, has a dominant role in OPEC pricing. When members violate OPEC agreements, the Saudis can increase production and lower prices, as from 1986 to 1988, threatening to drive high-cost producers out of the market. Still, even the Saudis were hurt by increased government spending and substantial royal perquisites amid negative growth during the 1980s and 1990s, facing major debt problems and political instability in the 1990s and early years of the 21st century. Middle Eastern oil producers account for 65 percent of the world’s reserves. Russia, with expansion of oil exploitation with integration into world capitalism, and Iraq, with recovery from the wars and conflict of the 1980s, 1990s, and early years of the 21st century, also should have major influences over cartel pricing. Trying to predict the responses of the Saudis, Russians, Iraqis, and OPEC’s weaker members indicates the difficulty of predicting how successful price collusion and future price trends will be.

Energy use depends on both income and price effects (with conservation measures being part of the price impact). The price elasticity of demand for energy increases with response time. Thus, in the first several months of the abrupt 1973 to 1974 oil price increase, the elasticity of demand for energy was close to zero (growth in amount demanded decreased little). Over the next seven-year period, price elasticities were about 0.4 percent in DCs and 0.3 percent in LDCs (growth in quantity demanded dropped substantially). The full effect of changing energy prices took

2In the late 1970s and 1980s, the Environmental Defense Fund, arguing that promoting conservation was cheaper than building new power stations, prodded California’s regulators to link Pacific Gas and Electric Company’s (PG&E) profits to its energy efficiency. For a time, PG&E’s conservation promotion became a model for electrical utilities and their regulators all over the world (Economist 1991:S13–S19).

TABLE 13-1. The World’s Leading Crude Oil Countries (by 2003 production and 2003 estimated proved crude oil reserves, billion tons)

The majority of U.S. and Chinese productions is consumed domestically. The U.S.’s 2003 excess demand (consumption less production) of 12.6 million barrels per day surpassed the total excess of the next three nations, Japan, China, and Germany, in rank order. South Korea, France, Italy, India, and Spain also had excess demand greater than one million barrels per day (International Energy Agency 2004:A8).

Proved reserves of oil are “those quantities that geological and engineering information indicates with reasonable certainty can be recovered in the future from known reservoirs under existing economic and operating conditions” (British Petroleum 2004:4).

Because production and reserve figures are used in apportioning OPEC country quotas, many of these figures are likely to be overstated.

a OPEC members.

Source: British Petroleum p.l.c. 2004.

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place 15–25 years later, when demand elasticities (in response to 1973–74 prices) are twice as high as for the seven-year period (Stobaugh 1979:31–33; World Bank 1981i:36–37).

Dutch Disease

Michael Roemer analyzes Dutch disease, named when the booming North Seas’ gas export revenues in the 1970s appreciated the guilder, making Dutch industrial exports more costly in foreign currencies and increasing foreign competition and unemployment. Spain’s discovery of gold and silver in the New World in the 16th century reduced the expansion of other productive activities. Analogously, the United States suffered from a similar disease from 1980 to 1984, experiencing a farm export crisis and deindustrialization from the decline of traditional U.S. export industries (automobiles, capital goods, high technology, railroad and farm equipment, paint, leather products, cotton fabrics, carpeting, electrical equipment and parts, and basic chemicals) during substantial capital inflows strengthening the dollar.3 Yet LDCs are less likely to catch Dutch disease from capital inflows than from a major world price increase, a cost-reducing technological change, or a major discovery of a primary resource. The pathology might better be called the Indonesian, Nigerian, Angolan, Mexican, Venezuelan (from petroleum), Thai (rice, rubber, tin), Malaysian (rubber, tin), Brazilian (coffee, sugar), Colombian (coffee), Coteˆ d’Ivoirian (coffee, cocoa, wood), Bangladesh (foreign aid inflows), Egyptian (tourism, remittances, foreign aid inflows), Jordanian (remittances), Zambian, Zairian (copper), or Ghanaian (cocoa) disease, an economic distortion resulting from dependence on one to three booming exports.

Roemer’s three-sector model shows that growth in the booming export sector reduces the price of foreign exchange, retarding other sectors’ growth by reducing incentives to export other commodities and replace domestic goods for imports and raising factor and input prices for nonbooming sectors. Moreover, labor moves from the lagging export and import substitution sectors to the booming and nontradable sectors. Other ill-effects of the export boom may be relaxed fiscal discipline, increased capital-intensive projects, and wage dualism. Government can minimize the negative effects of Dutch disease by investing in the lagging traded goods sector before the natural resource is exhausted, so that the rest of the economy can capture the potential benefits of the export boom (Roemer 1985:234–252; see also Findlay 1985:218–233; Corden and Neary 1982:825–848).

Resource Curse

Oil booms have proven a blessing for many oil-exporting countries, such as Norway, which invested in other sectors, increasing the sustainability of its welfare state. But

3The discussion in Chapter 17 of infant entrepreneurship indicates that Mexico and Argentina suffered from a similar disease, a foreign-investment blitz, in the early 1990s. Chile, however, limited the impact of this illness through taxes on capital inflows, designed to increase the portion of middle-term and long-term investment.

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unsustainable overconsumption in resource-abundant economies.5 Indeed, he agrees that Nigeria was living beyond its means during its oil boom.

Finally, an abundance of exportable minerals and other resources is more likely to be associated with poor governance or even a failed state. These resources enabled warlords or predatory rulers (Liberia’s Charles Taylor and Zaire’s Mobutu Sese Seko) to support private armies without providing public services. Indeed, predatory economic behavior is possible in resource-abundant economies but less viable in resource-poor Tanzania, whose resources are too limited for extensive rent seeking (Nafziger and Auvinen 2003).

Poverty and Environmental Stress

Grinding poverty and impatience may spur people to strive for immediate gain, forgetting long-term sustainability, especially when property or use rights are unclear. To survive, impoverished people degrade and destroy their immediate environment, cutting down forests for fuelwood and export earnings, overusing marginal agricultural land, migrating to shrinking areas of vacant land, and destroying habitat for biological species essential for pharmaceuticals and seed varieties (Norgaard 1992:38–40; U.N. World Commission on Environment and Development 1987:28). Additionally, they forego maintenance of vegetation, forests, and the biosphere. At subsistence levels of living, when peoples’ survival is at stake, hand-to-mouth economics prevail in which the future is infinitely discounted; people overexploit natural resources and underinvest in conservation and regeneration, leading to resource depletion and species loss. In this economic climate, people make irreversible decisions, foreclosing options by logging and mining of rain forests and other economic options that reduce species (Panayotou 1993:46–54; Flavin 1989). More than 100 million people in LDCs experience acute firewood shortages. In the late 1980s, a study of Nepalese hill villages with severe deforestation indicated one-quarter of the household labor normally devoted to agriculture was diverted to fuelwood collection (Mink 1993: 8–9).

The World Bank (1992i:4) lists the following adverse effect of environmental degradation on health and productivity: (1) water pollution contributes to more than two million deaths and billions of illnesses a year; water scarcity results in poor household hygiene, added health risks, and limits on economic activity; and water pollution and scarcity leads to declining fisheries, increased municipal and rural household costs of providing safe water, and aquifer depletion, which leads to irreversible compaction;

(2) excessive urban particulate matter is responsible for 300 to 700 thousand premature deaths annually and for half of childhood chronic coughing; smoky indoor air affects 400 to 700 million people, mainly women and children in poor rural areas;

5A study by The World Bank (“Striking It Poor: Oil as a Curse,” World Bank Development News, June 9, 2003) reconfirms the association of the curse with over-consumption and excessive military spending. The result is that the Bank, in lending to Chad for an oil pipeline, conditioned the loan on Chad adopting “anticorruption laws and promis[ing] to spend most of its oil money on projects like health care and rural development” rather than military spending.

and air pollution has many acute and chronic health impacts, it restricts vehicle and industrial activity during critical episodes, and affects forests and water bodies through acid rain; (3) solid and hazardous wastes acutely increase health risks locally, such as diseases spread by rotting garbage and blocked drains; and groundwater resources are polluted; (4) soil degradation reduces nutrition for poor farmers on depleted soils and increases susceptibility to drought, whereas decreasing field productivity in tropical soils contributes to offsite siltation of reservoirs, river-transport channels, and other hydrological investments; (5) deforestation leads to localized flooding, contributes to death and disease, and also leads to the loss of sustainable logging potential, erosion prevention, watershed stability, and carbon sequestration6 provided by forests; (6) reduced biodiversity contributes to loss of new drugs and genetic resources, and reduced ecosystem adaptability; and (7) atmospheric changes, which shift vector-borne diseases, increase risks from climatic natural diseases, and increase diseases from ozone depletion (estimated to contribute to as much as 300 thousand additional cases of skin cancer and 1.7 million cases of cataracts a year worldwide).

Poverty and insecurity contribute to lack of capital and labor to conserve the environment. Poor, landless people are forced to cultivate marginal lands, lacking other alternatives. Low-income countries will pay little, if any, to avoid climatic and biological resources degradation.

Grassroots Environmental Action

The transition to sustainable development generally requires local participation in managing resources. The U.N. Research Institute for Social Development (UNRISD) researchers Dharam Ghai and Jessica M. Vivian (1992) contend that low-income local people operating small-scale schemes based on longstanding knowledge of the soil and terrain usually resist large-scale commercialization (dams, irrigation projects, fishing trawlers, timber) by government or firms that fail to consult local people or bear the costs of degradation. Grassroots action in defense of the environment, especially in democracies such as India, can have a significant impact, even in the face of opposition of entrenched interest groups whose profits lie in overexploiting resources. Local people who are not just defending the “environment” in the abstract but their livelihood and their way of life are difficult for ruling elites to quell.

How do we reconcile UNRISD findings with those of the U.N. (Brundtland) Commission? Robin Broad, who conducted fieldwork in rural communities across the Philippines, argues that the poor who live in a stable ecosystem, with secure long-term user rights, will behave responsibly toward the environment. However, when events and institutions transform poor people “into marginal people living in vulnerable and fragile ecosystems,” they will destroy and degrade their environment (Broad 1994:811–822).

6See Regalado and Ball (2004:A1) on the potential of the technology of carbon sequestration to reduce carbon dioxide concentrations.

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Market Imperfections and Policy Failures as Determinants of

Environmental Degradation

Theodore Panayotou (1993) argues that environmental degradation originates from market distortions, defective economic policies, and inadequate property rights definitions, that is, that environmental problems are, at heart, economic problems. Market and policy failures mean a disassociation of scarcity and prices, benefits and costs, rights and responsibilities, and actions and consequences. People maximize profits by shifting costs onto others and appropriate common and public property resources without compensation. Market failures are institutional failures partly attributable to the nature of certain resources and partly to the failure of the government to establish fundamental conditions for efficient markets and use instruments (taxes, regulations, public investment, and macroeconomic policies) to bring costs and benefits that institutions fail to internalize into the domain of the market. Policy failures are cases of misguided government intervention in fairly well functioning markets or unsuccessful attempts to mitigate market failure which results in worse outcomes. However, society’s goals cannot be eliminating environmental deterioration altogether but, rather, accounting for all costs from diminished quantity and quality and lost diversity of natural resources, considering the productivity and sustainability of alternative resource uses, and insisting that environmental costs are borne by those who generate them. Growth must be derived from increased efficiency and innovation rather than by shifting environmental costs onto others.

Following are six market imperfections that contribute to environmental degradation.

(1) Externalities. Externalities refer to economic activities conveying direct and unintended costs and benefits to other individuals and firms. The concept of external economies, discussed in Chapters 5 and 11, also includes negative externalities or external diseconomies. These diseconomies include air pollution (from steel plants and automobile exhausts), water pollution, and depletion of fisheries by overfishing.

You can trace almost all resource problems to discrepancies between the private and social valuation of resources. In general, overexploitation, inefficient use, inadequate conservation, and the lack of investment in the regeneration of natural resources arise from the failure of either the market or government to price resources according to social scarcity.

Government should identify spillovers (externalities) ignored in calculating private benefit–cost or user costs over time (where current resource use affects the future resource available), and internalize these costs or charge them to the current consumers and producers through taxation or modifying prices (rather than future generations or innocent bystanders from the present generation). Examples include the state levying taxes on polluters or charging a surcharge for pesticide use (Panayotou 1993:39–45). Government here has a more active role than when operating under Coase’s theorem (Box 13-1).

BOX 13-1. COASE’S THEOREM

Coase’s theorem states that when property rights are well defined and legally enforceable, and transactions (transfer and enforcement) costs are not prohibitive, participants will organize their transactions voluntarily to achieve efficient (mutually advantageous) outcomes. Environmental protection benefits those wanting clean air (John Q. Public) and costs the polluter (Hackett 1998:201). If the benefits of clean air exceed its costs, then an efficient outcome would be for John Q to pay the polluter, or vice versa. To minimize price distortion, it does not matter which party has a property right to use of the air. Both John Q and the polluters are better off without government intervention (Coase 1993:109–138; Glaeser, Johnson, and Shleifer 2001:853; Hackett 1998:101–104). But the Coasian approach faces difficulties with complex issues such as global warming.

Coasian contracting operates well, given the restrictive assumptions above. Transaction and negotiation costs are additional problems. Another problem is free riding by third parties. In both free rider and tragedy of the commons problems, individual incentives based on self-interest are not consistent with group optimum (Hackett 1998:104).

Furthermore, although the Coasian approach might work well between small numbers (for example, a cattle rancher bargaining with a wheat farmer about payment for a fence), it works less well with large numbers, especially on the buying side (ibid.).

Panayotou (1993) and other mainstream economists stress the idea that people should pay for costs they shift to others, but, unlike Coase, they see an essential role for the state in allaying market failure. A view similar to Coase tends to be skeptical about government regulation. One reason is the cost of coordination, bargaining, monitoring, and contract enforcement. Another reason is a preference for being free of state action.

(2) Common property resources. The biologist Garrett Hardin’s (1968:1244–1245) “tragedy of the commons” implies that just as the herder’s cattle eventually overgraze a pasture open to all, so do businesses and individuals overpollute atmosphere and overuse biosphere free for all to use.7 Individuals exploit an unpaid or open access resource as if they were facing an infinite discount rate. Indeed, having large families, although harmful to society, is optimal for a couple exploiting the commons. Families, factories, fishers, and herders that generate environmental costs should bear the costs they convey to others through the degradation of air, water, and pastures.

During the last quarter of the 20th century, West Africa, facing foreign exchange shortages, has exported substantial amounts of timber. Additionally, tens of thousands of West Africans cut down timber to mitigate acute firewood shortages. West Africa’s rate of tropical deforestation during the 1980s was 0.8 percent yearly; by 1997, few of these forests remained (Tham 1992:25–37; World Bank 1992i:6; Panayotou 1994:151–152).

7Peirson (1994:218) points out that free open access to grazing land need not necessarily destroy the usefulness of land. Overgrazing depends on the private costs of raising cattle, their market value, and the ability of the land to support large numbers of cattle.

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In Haiti, violence, displacement, erosion, and poverty interact, producing a protracted social and political crisis. The lack of well-defined property and use rights contributes to falling rural per-capita income. Population growth leads to erosion through an increasing demand for fuel. For the poor there is no substitute for wood and charcoal; their use has led to massive deforestation (Lundahl 2000:333–364). The farmer Didier Dipera says: “There are no trees to hold the land and when it rains the earth washes away” into the river and down to the sea (Weiner 2004). The accelerating erosion process had contributed to a long-term decline in agriculture’s productive capacity, and has provided a powerful incentive for rural–urban migration, increasing population pressure and political discontent further (Lundahl 2000:333–364).

From time immemorial, however, cultures have discovered the dangers of commonproperty tenure and have developed property rights, sometimes group tenure or coordination of hunting and gathering, to protect their resources. In the evolution of humankind, only those cultures survived that developed institutions to limit commonproperty resource use (Gordon 1993:97–108).

Esther Boserup (1965) emphasizes how population growth affects the evolution of land rights when land is no longer abundant. Rising land value and scarcity necessitate regulating land use. Frequently, land rights that had been open access were individualized, with well-defined users (Munoz-Pina, Janvry, and Sadoulet 2003:129).

(3)Public goods. Many environmental resources are public goods, which are characterized by nonrivalry and nonexclusion in consumption. Nonrivalry means that one individual’s consumption of the good (lighthouses, biodiversity of species, oceans) does not diminish the amount of good available for others to consume. Nonexclusion means that if one person is able to consume the good (the atmosphere, flood protection, national defense, and police fire protection), then others cannot be excluded from consuming it (Kahn 1995:18).

(4)Irreversibility. Many environmental and natural resource goods cannot be reproduced in the future if we fail to preserve them now. The market makes inadequate provision for the future of a rare phenomena of nature (the Grand Canyon), a threatened species (the elephant), or an ecosystem (the tropical rain forest) essential for the survival of a species. We should place a high value on retaining options to use goods or services that would be difficult or impossible to replace and for which there are no close substitutes (Krutilla 1993:188–198). Logging or mining of the tropical rain forest, the habitat for about half of the world’s biological species, destroys the species that are essential for the pharmaceuticals and seed varieties that humankind needs in the future.

(5)Undefined user rights. People will not pay for or conserve a resource without the assurance of secure and exclusive rights over it. The overuse of common property resources ensues from legally unclear ownership and user rights to an asset. In Thailand, subsistence farmers, without long-term tenure rights, “mined” the soil