Biodiversity: an underappreciated factor of production

Economic opinion

Adding to the myriad of reasons for global policymakers to take serious steps towards mitigating climate change, the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) published a stark warning two weeks ago. Biodiversity is plummeting and about one million plant and animal species out of the estimated eight million on the planet are at risk of extinction, many within the next decades. Beyond a purely environmental perspective, this warning is also startling in terms of the global economic outlook. The natural environment and its processes provide numerous benefits to humans, including in economic ventures. As such, an ecosystem’s biodiversity is arguably a very important factor in determining potential growth. Furthermore, just as investments need to be made to offset the depreciation of other assets, investments are needed to protect and restore the environment. This is one example of how the realities of climate change require economists to adapt their thinking, and one further reason why policymakers must act now to mitigate climate change.

Potential output: an elusive concept

Potential output is a crucial yet elusive concept in economics. It is often defined as the maximum sustainable (that is, without causing inflation) output an economy can produce given the capital stock, the structural labour input and productivity. It is therefore different than actual GDP and is used to distinguish between shorter-term cyclical dynamics and structural changes in trend growth. If actual GDP growth is below potential growth there is said to be an output gap. This concept can be used by central banks to assess the appropriate stance of monetary policy and by governments to assess fiscal policy from a more structural perspective. Thus, the measurement of potential growth has important policy consequences.

Potential growth, however, cannot be observed or measured outright and must be estimated instead. Furthermore, there are many ways to estimate potential growth. Statistical methods look at historical real GDP series and break them into trend and cyclical components (with the trend representing potential output). The production function approach, in contrast, relies on economic theory to determine a relationship between factors of production (capital, labour, technology etc.) and potential output. This relationship is known as the production function. A commonly used example of such a production function is the Cobb-Douglas Function:

Y = ALα K(1-α)

where Y = output, L = labour input (hours worked), K = capital input, α = the output elasticity of labour, and A = total factor productivity (the change in output that cannot be accounted for by changes in inputs L and K. It is often associated with technological change.)

Besides the different methods for estimating potential output, and the different production functions that can be assumed, there are also differences in determining and measuring what exactly comprises the capital stock. Is only physical capital included, such as machines, equipment and factories, or does it also include land? Regardless, whatever is not captured by the labour and capital inputs is captured instead by total factor productivity.

Biodiversity: an underappreciated factor of production

Conservationists have long warned of the importance of preserving nature and Earth’s biodiversity, but such warnings can go in one ear and out the other for those who feel removed from nature in their everyday lives. As the IPBES points out, however, humans rely on the natural environment for “food, feed, energy, medicines and genetic resources, and a variety of materials.” We also depend on environmental processes for fresh water, clean air, rich soil, pollination of more than 75% of global food crops, pest control, and the capture of 60% of human-produced carbon emissions. From an economic perspective, these natural assets have tangible benefits for productivity and output that can even be measured in dollar terms. The IPBES, for example, states that “land degradation has reduced productivity in 23 percent of the global terrestrial area, and between $235 billion and $577 billion in annual global crop output is at risk as a result of pollinator loss.” Those figures represent 9-22% of total agricultural crop production in 2016. Thus, the health of Earth’s biosphere clearly contributes to potential growth, even if it is not explicitly measured or identified as an input.

Other known impacts of climate change may also have a negative effect on potential output and output itself. First, the increasing prevalence of extreme weather can impact crop production, prevent some workers from getting to work, interfere with supply chains, and shrink consumption (though there would be an expected bounce back for some but not all spending when the weather improves). Many economists attributed the temporary contraction of the US economy in Q1 2014, for example, to several severe snowstorms that hit the country that winter. Second, the deterioration of air and water quality increases health risks that could in turn hinder the size of the labour force. Third, the decline in diversity of plants and animals undermines the resilience of agricultural systems and increases the risk of sudden severe declines in food production. As such, the warning from the IPBES should be heeded by economists and policymakers globally. If steps are not taken to prevent the path laid out by IPBES, potential growth will suffer (among many other things).  

A need for investment

The realities of climate change require economists to adapt their thinking, including on the measurement and estimation of potential growth. For example, when economists estimate the future capital stock, they also incorporate the concept of depreciation: 

Kt=(1-δt ) K(t-1)+It

where δt = the depreciation rate and It = new investment. When discussing physical capital, this depreciation represents the normal wear and tear of factories and machinery, or the process of software becoming outdated. Depreciation also occurs with human capital, usually as skill sets become obsolete or a large share of the population is out of work for an extended time and falls behind in terms of training. It also makes sense then, to talk about the depreciation of the natural environment. As humans make use of the environmental assets mentioned above, this use weighs on the productive capacity of the environment. Therefore, just as investments need to be made to replenish the capital stock—whether that is buying new equipment, updating software, or investing in the education of the labour force—so too do investments need to be made to protect and replenish the environment.

The UN estimated in 2011 that green investments worth 2% of global GDP would lead to long-term growth over 2011-2050 “that could be at least as high as an optimistic business-as-usual scenario, while minimizing the adverse impacts of climate change, water scarcity and the loss of ecosystem services.” When one considers that those adverse impacts of climate change are likely not compatible with a business-as-usual scenario in terms of economic growth, it becomes clear that policymakers should act now to mitigate climate change.


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