Zeroth Order Draft Markets and Development

10.9.       Impacts on markets and development

Prior sections of this chapter present the direct impacts of climate change on the economy sector by sector. There are, however, also indirect impacts. The effects that impacts in one sector may have on the rest of the economy are initially presented, followed by the impacts on economic growth and development.

10.9.1.    General equilibrium effects

General equilibrium analysis describes how climate change impacts in one sector propagate to the rest of the economy; and how the changed macroeconomic context feedbacks on the sector. There are three channels through which impact diffuse. First, outputs of one sector are used as inputs to other sectors. For example, a change in crop yields would affect the food-processing industry. Second, products compete for the consumers’ finite budget. If, for example, food becomes more expensive, less money would be spent on other goods and services. Third, sectors compete for the primary factors of production (labor, capital, land, water). If more labor is needed in agriculture to offset a drop in crop yields, less labor is available to produce other goods and services. Firms and households react to changes in relative prices, domestically and internationally.

General equilibrium models provide a comprehensive and internally consistent analysis of the medium-term impact of climate change on economic activity and welfare. However, these models necessarily make a number of simplifying assumptions, particularly with regard to the rationality of consumers and producers and the absence of market imperfections.

Computable general equilibrium models have long been used to study the wider economic implications of changes in crop yields (Kane et al., 1992). (Yates and Strzepek, 1998) show for instance that the impact of a reduced flow of the Nile on the economy of Egypt is much more severe without international trade than with, because trade would allow Egypt to focus on water-extensive production for export and import its food.

Older studies focused on the impact of climate change on patterns of specialization and trade, food prices, food security and welfare (Darwin and Kennedy, 2000; Darwin, 2004; Kane et al., 1992; Reilly et al., 1994; Winters et al., 1998; Yates and Strzepek, 1998). This has been extended to land use (Lee, 2009; Ronneberger et al., 2009), water use (Calzadilla et al., 2011; Kane et al., 1992), and multiple stresses (Reilly et al., 2007). General equilibrium models have also been used to estimate the value of improved weather forecasts (Arndt and Bacou, 2000), a form of adaptation to climate change. Computable general equilibrium analysis has also been used to study selected impacts other than agriculture, notably sea level rise (Bosello et al., 2007; Darwin and Tol, 2001), tourism (Berrittella et al., 2006; Bigano et al., 2008), human health (Bosello et al., 2006) and energy (see 10.2).

(Bigano et al., 2008) study the joint impacts on tourism and coasts, finding that tourism dominates the welfare impacts. (Kemfert, 2002) and (Eboli et al., 2010) estimate the joint effect on the world economy of a range of climate change impacts, but conflate general equilibrium and growth effects. (Aaheim et al., 2010) analyze the economic effects of impacts of climate change on agriculture, forestry, fishery, energy demand, hydropower production, and tourism on the Iberian peninsula. They find positive impacts on output in some sectors (agriculture, electricity) negative impacts in other sectors (forestry, transport) and negligible ones in others (manufacturing, services). (Ciscar et al., 2011) study the combined effect of agriculture, sea level rise, river floods and tourism on the European economy. They find a welfare loss of 0.2-1.0% of income by the end of the century for the European Union. There are large regional differences with losses in Southern Europe and gains in Northern Europe.

The following initial conclusions emerge. First, markets matter. Impacts are transmitted across locations—with local, regional and global impacts-- and across multiple sectors of the economy.. For instance, landlocked countries are affected by sea level rise because their agricultural land increases in value as other countries face erosion and floods. Second, consumers and producers are often affected differently. The price increases induced by a reduction in production may leave producers better off while hurting consumers. Third, the distribution of the direct impacts can be very different than the distribution of the indirect effects.  For instance, a loss of production may be advantageous to an individual company or country if the competition loses more. Fourth, a loss of productivity or productive assets in one sector leads to further losses in the rest of the economy. At the same time, fifth, markets offer options for adaptation, particularly possibilities for substitution. This changes the size, and sometimes the sign of the impact estimate.

10.9.2.    Growth effects

10.9.2.1.        The rate of economic growth

Climate change would also affect economic growth and development, but our understanding is limited.  (Fankhauser and Tol, 2005) investigate four standard models of economic growth and three transmission mechanisms: economic production, capital depreciation, and the labor force. They find that, in three models, the fall in economic output is slightly larger than the direct impact on markets – that is, the total impact is more than twice as large as the direct impact – while the 4th model (which emphasizes human capital accumulation) points to indirect impacts that are 1.5 times as large as the direct impacts. The difference can be understood as follows. In the three models, impacts crowd out consumption and investment in physical capital, while in the fourth model investment in human capital too is crowded out. (Hallegatte, 2005) reaches a similar conclusion. (Hallegatte and Thery, 2007; Hallegatte and Ghil, 2008; Hallegatte and Dumas, 2009) highlight that the impact of climate change through natural hazards on economic growth can be amplified by market imperfections and the business cycle. (Eboli et al., 2010) use a multi-sector, multi-region growth model. The impact of climate change would lead to a 0.3% reduction of GDP in 2050. Regional impacts are more pronounced, ranging from -1.0% in developing countries to +0.4% in Australia and Canada. Sectoral results are varied too, with output changes ranging from output of +0.5% for power generation (to meet increased demand to air conditioning) to -0.7% for natural gas (as demand for space heating falls) and rice.

Using a biophysical model of the human body’s ability to do work, (Kjellstrom et al., 2009) find that by the end of the century climate change may reduce labor productivity by 11-27% in the humid (sub)tropics. Assuming a output elasticity of labor of 0.8, this would reduce economic output in the affected sectors (involving heavy manual labor without air conditioning) by 8-22%. Although structural change in the economy may well reduce the dependence on manual labor and air conditioning would be an effective adaptation, even the ameliorated impact would have a substantial, but as yet unquantified, impact on economic growth.

In a statistical analysis, (Dell et al., 2009) find that one degree of warming would reduce income by 1.2% in the short run, and by 0.5% in the long run. The difference is due to adaptation. (Horowitz, 2009) finds a much larger effect: a 3.8% drop in income in the long run for one degree of warming. In a yet-unpublished study, (Dell et al., 2008) find that climate (change) has no effect on economic growth in countries with an income above the global median ($^PPP,20003170) but a large impact on countries below the median. If companies can fully adapt to a new climate in 10 years time, economic growth in the 21st century would be 0.6% slower if climate changes according to the A2 scenario than in the case without climate change. If economic growth is 2.6% per year without climate change, and 2.0% with, then a century of climate change would reduce income by 44%.

10.9.2.2.        Poverty traps

Poverty is concentrated in the tropics and subtropics. This has led some analysts to the conclusion that a tropical climate is one of the causes of poverty. (Gallup et al., 1999) emphasize the link between climate, disease, and poverty while (Masters and McMillan, 2001) focus on climate, agricultural pests, and poverty. Other studies (Acemoglu et al., 2001; Acemoglu et al., 2002; Easterly and Levine, 2003) argue that climatic influence on development disappears if differences in human institutions (the rule of law, education, etc) are accounted for. However, (Van der Vliert, 2008) demonstrates that climate affects human culture and thus institutions, but this venue has yet to be explored in the economic growth literature. (Brown et al., 2011) find that weather affects economic growth in Sub-Saharan Africa – particularly, drought decelerates growth. (Jones and Olken, 2010) find that exports from poor countries fall during hot years. (Bloom et al., 2003) find limited support for an impact of climate (rather than weather) on past growth in a single-equilibrium model, but strong support in a multiple-equilibrium model: Hot and wet conditions and large variability in rainfall reduce long-term growth in poor countries (but not in hot ones) and increase the probability of being poor.

(Galor and Weil, 1996) speculate about the existence of a climate-health-poverty trap. (Bonds et al., 2010) and (Strulik, 2008) posit theoretical models and offer limited empirical support, while (Tang et al., 2009) offers more rigorous empirical evidence. This is further supported by yet-to-be-published analyses (Bretscher and Valente, 2010; Gollin and Zimmermann, 2008; Gollin and Zimmermann, 2010; Ikefuji et al., 2010). Climate-related diseases such as malaria and diarrhea impair children’s cognitive and physical development. This leads to poverty in their later life so that there are limited means to protect their own children against these diseases. Furthermore, high infant mortality may induce parents to have many children so that their investment in education is spread thin. An increase in infant and child mortality and morbidity due to climate change would thus trap more people in poverty.

(Zimmerman and Carter, 2003) build a model in which the risk of natural disasters causes a poverty trap: At higher risk levels, households prefer assets with a safe but low return. (Carter et al., 2007) find empirical support for this model at the household level, but (van den Berg, 2010) concludes the natural disaster itself has no discernible impact on investment choices. At the macro-economic level, natural disasters disproportionally affect the growth rate of poor countries (Noy, 2009).

(Bougheas et al., 1999; Bougheas et al., 2000) show that more expensive infrastructure, for example because of frequent repairs after natural disasters, slows down economic growth and that there is a threshold infrastructure cost above which trade and specialization do not occur, suggesting another mechanism through which climate could cause a poverty trap. The implications of climate change have yet to be assessed.

10.9.2.3.        Conclusion

In sum, the literature on the impact of climate and climate change on economic growth and development has yet to reach firm conclusions. There is agreement that climate change would moderate the rate of economic growth, by a little according to some studies and by a lot according to other studies. There is disagreement whether climate change would affect the nature of economic development, with some studies suggesting that more people may be trapped in poverty and fewer people enjoying exponential growth.

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