The equation economists get wrong

Gains and Losses

The Western system of economic accounting, which, with globalization, has swept to the four corners of the earth, contains a serious flaw that jeopardizes the environment.

It’s a flaw based on a false assumption.

Conventional economics assumes that people put an equal value on gains and losses. And upon that assumption are based bookloads of procedures for calculating the value of environmental features.

For instance, when trees are to be cut in Algonquin Park, and people object to  defacing the park, the response has always been that the value of the jobs is greater than the loss to the park. And the calculation is based on valuing the gain to the loggers on equal terms with the loss to the park.

But in reality people don’t put an equal value on losses and gains. They put a much higher value on losses than they do on gains.

According to Jack Knetsch, a professor of economics at Simon Fraser University, a long string of behavioural studies show that the value people place on losses is nearly four times greater than that placed on gains. (His findings are detailed in Assumptions, Behavioural Findings, and Policy Analysis,  published in the Journal of Policy Analysis and Management, vol. 14, No. 1 (1995), pages 68-78.)

The right question to ask in determining how much a loss to Algonquin would be worth, Knetsch says, is: « How much money would it take to persuade you, the public, to accept this loss?’’

On the other side of the equation, the question to the logging company would be: « How much are you prepared to pay for the right to log these lands?’’

According to what Knetsch is saying, logging companies should be paying four times as much as they do to log in Algonquin. Otherwise, the Ontario government is giving them an enormous subsidy at taxpayers’ expense.

It may be that the government is justified in providing such a subsidy. But it should be acknowledged, and it should be a matter of public debate.

This kind of mis-accounting works in yet another way to jeopardize the environment. It puts too low a priority on protecting the environment.

Here’s how it works. Economists have a way of calculating the present value of something in the future. It’s called discounting future costs and benefits. It answers the question, « How much is this future benefit worth to me right now?’’ Or, « What dollar value would I assign today to this loss that’s happening in the future ?’’

In these equations, the bigger the costs are in today’s terms, the more urgent is the need to deal with the problem right away.

The difficulty is that economists use the same discount rate for both future gains and future losses. In other words they place the same value on each. For instance, cutting the Temagami old growth forest over a period of years (a loss) would be valued by the same economic standard as building a new highway over a similar period (a gain).

But if the loss in Temagami were valued four times higher, as it should be, priorities could change. Keeping the forest might be accounted more valuable to society than the highway — in which case, logging wouldn’t be allowed, building the highway could be postponed, and money saved from the postponement could be used to relocate forest workers.

Once you accept that people value losses more than gains, there are enormous implications in almost every field of activity, says Knetsch. For instance, lawyers can expect juries to award higher damages if they picture their client as suffering a loss instead of missing out on a gain.

To get economists to shift their thinking closer to the reality of how people act is going to be a tough job. For them it will be a loss — giving up an assumption they have held dear ever since they wrote their first exams at university.

How to turn this loss into what they can see as a gain will be a challenge for the rest of us.

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