Economic Analysis in Brief

Much of what constitutes "economic analysis" is not really very controversial. It is simply a way of thinking about choices and about the costs, benefits, and trade-offs that underlie those choices. A basic notion in economics is that we make trade-offs "at the margin." We do this on a daily basis, for example, when we allocate our time between work and play, or when we allocate money between spending and saving. Groups of individuals—such as households, organizations, towns, or countries—face similar kinds of collective choices, and economics has a systematic way of thinking about these trade-offs as well and of applying these ideas to a wide range of situations. Economics also tries to understand how individuals behave and how they respond to incentives of various kinds. This makes it possible to evaluate how a given change in incentives—such as a change in government policy—is likely to alter individuals' actions.

Economic analysis is essential for the environment because environmental issues are fundamentally economic ones: people cause environmental problems because of their choices, and people distinguish small environmental problems from large ones based on their values. It follows that finding solutions to environmental problems requires understanding those values and those choices. That is what economics tries to do. It tries to understand people's individual incentives and choices, as well as the collective opportunities and constraints faced by society as a whole.

To help us get started, let's take a look at some key economic concepts and ideas and then apply them to the example of water. Water provides a good example because it is both a resource and a commodity, and it's also an essential ingredient in ecosystems and habitats. The availability of water depends on many things, including the choices made by individuals and households, towns and cities, and countries. So, as we introduce these key economic ideas, we'll consider how they relate to the allocation of water and how a small community might apply these economic ideas and tools to water allocation issues.

One note of caution: What follows is a compact overview of some big issues and ideas, which may make the delivery in this first chapter seem more like a fire hose than a drinking fountain to some readers. Don't despair. The intention here is to introduce some key ideas and to entice. A more detailed, step-by-step approach follows in the remaining chapters. Also, a number of key concepts used throughout the book are shown here in bold, followed by brief definitions or explanations. More detailed discussions of each can be found in later chapters.

Marginal versus Total Value

One of the most fundamental concepts in economics is the idea of marginal value , such as the value of one additional gallon of water, one more hour spent studying, or the value of one more dollar spent on junk food. When we make choices that involve the allocation of a resource to a particular use, or when we give something up that is valuable to us, almost always we are doing this "at the margin." This means we are making only an incremental change in the amount of the resource being allocated to a particular use as compared with other uses, for example, when a household allocates water for drinking, bathing, or gardening.

When we do this, it makes sense to consider the incremental or marginal benefit of this particular change. Even though the value of the first unit of a particular good or service may be very high to us, it is likely that with additional quantities the marginal value will decline. Economists call this diminishing marginal utility. It is extremely important to recognize the difference between marginal value and total value because while a particular good may have an extremely high total value (for the whole amount used), this does not necessarily mean that the marginal value of one additional unit of that good is also extremely high. For example, because we cannot live without water, the total value of water can be thought of as being infinite. But the value of an additional gallon of water may be close to zero if we are at the point where all our current needs for water have been satisfied.

Economists illustrate this graphically as in figure 1.1, where the marginal or incremental value of one additional unit of a good (like water) or a service (like a haircut) may be very high when the quantity used (in a given period of time) is low, but will generally decline at higher levels of consumption or use. At a very high level of use, the marginal value of water will eventually fall to zero (somewhere off the right end of the horizontal axis in figure 1.1). But at a very low level, water will have an exceedingly high marginal value—for example, when thirst becomes a life or death situation.

Since the total value is just the adding up of all the incremental or marginal values from the first gallon to the last gallon, even in a situation where the marginal value is very low, the total value may be very high for an example like water. The marginal value at low levels isn't even shown in figure 1.1 because it goes off the top of the graph. If the marginal value is infinite at very low quantities, then the total value will be infinite as well, even though the value of the last gallon consumed is very low. Individually and collectively, we face many choices, but these usually involve incremental changes in resource allocation. That is why we should often focus on the incremental changes in value for a given use rather than the total value.

Opportunity Cost

A second key concept in economics is opportunity cost. Nearly all choices involve trade-offs. That means that a choice to allocate a resource to one use necessarily implies not putting it to some other use. By not putting a resource to that other use, you give up the benefits from that other use, and this is the opportunity cost. Using water to water the garden means giving up its value for drinking or bathing. Cutting down a tree to build a house means giving up its value as part of a forest. Spending time exercising implies giving up the value of that time for working.

In general, the more of a thing we take away from one use and put to another, the higher the opportunity cost. The relationship can be appreciated by looking again at drinking...