ECONOMICS:Economists work on the principle that our resources are scarce, so what do they think we should do about it, asks Paul Tansey, Economic Editor

Economists are usually portrayed as enemies of the environment. They are seen to be obsessed with economic growth, interested only in those aspects of life that can be measured by money, therefore knowing the price of everything and the value of nothing.

It's quite a charge sheet. But there is a case for the defence.

For a start, economics is founded on the principle that physical resources are scarce, a view it shares with the Green movement.

The objective of economics is to ensure that these scarce resources are used to best effect to enhance material wellbeing. Lionel Robbins, later the author of the great wave of university expansion in Britain during the 1960s, defined economics as "the relationship between ends and scarce means that have alternative uses".

From its inception, economics has always been concerned with the problem of physical scarcity. The first great wave of ecological pessimism occurred in the early 19th century and it left an indelible imprint on the development of economics.

It was driven by fears that rapid rates of population growth would outstrip the available supply of food, a case made most forcefully by Thomas Malthus. Faced by the need to feed a rising population, David Ricardo analysed the effects of bringing increasingly marginal agricultural land into production. His results - including the law of diminishing returns - provided the first systematic presentation of classical economic theory.

Paradoxically, this former stockbroker also exerted a major influence on the economics of Karl Marx.

So, with economists accepting the inevitability of scarcity from the outset, what had they to say about how these scarce resources should be used?

Essentially, economists see markets as the best method of allocating scarce resources between competing uses. In any market, where demand outstrips supply, prices rise. The price mechanism thus operates to ration scarce resources, ensuring that they are allocated to their most productive use.

Thus, in current markets, growing demand for scarce oil, itself a product of rapid Asian economic growth, has pushed up the price to around $100 (€68) a barrel. But, for economists, this is the beginning, not the end, of the market story.

High oil prices in themselves reduce the demand for oil, as some cannot afford to pay the new, higher price. As a result, rising prices curb demand and this in itself acts as a brake on economic growth. But the dynamic effects of market responses to high oil prices go much further.

First, higher oil prices act to increase the supply of oil in two ways. Rising prices make marginal oilfields commercial and therefore worth exploting. Oilfields that were uncommercial when oil was priced at $50 (€34) a barrel are profitable to exploit when oil is hovering around $100 a barrel.

In addition, the lure of high prices stimulates new oil exploration activity. Following the jump in oil prices in the 1970s, accelerated exploration activity discovered many new oil fields, from Vietnam to West Africa.

In the second place, a high price for one type of energy induces a search for substitutes. High oil prices force energy innovation. Wind energy, with Airtricity an outstanding example, wave power and biofuels can be seen as innovative responses to rising conventional energy prices.

Third, higher oil prices strengthen innovation through the search for efficiency gains. Thus, the last oil crisis induced not only a switch from large gas guzzlers to compact cars, but much greater fuel efficiencies even in conventional cars.

At a macroeconomic level, and partly in response to changes in relative energy costs, the last quarter of a century has witnessed a move away from energy-intensive heavy industries to knowledge-based industries and services as the principal sources of growth in the leading industrial countries. Gross National Product has become lighter as a result. And as it has become lighter, it has become less energy-intensive.

While economists rely principally on markets as the best mechanisms to allocate scarce resources, they have long been conscious that there are limits to the reach of the market. One of the first identified cases of market malfunction related to the economics of pollution.

In a market system, private businesses recognise only the private costs - wages, raw materials, energy - that they themselves must bear in the process of production. Left to themselves, businesses are unconcerned with the social costs - or benefits - they impose on the rest of society.

To take an example dating as far back as 1890: where a factory emits smoke in the process of production, it imposes social costs on the neighbourhood in the form of pollution.

Since the cost of pollution is not borne by the offending factory owner, but by society as a whole, it can be shown that the social costs of production exceed the value of output produced and, as a result, the quantum of production is excessive even in terms of conventional market analysis.

The divergence between social costs and private benefits exists because of the existence of negative external or spillover effects.

Unfortunately, they are increasingly common. A manufacturing plant may pollute the atmosphere by emitting smoke or noxious fumes. Farmers may pollute the water supply by discharging waste into local rivers. Moreover, such negative spillover effects can transcend borders, as where a nuclear plant in one country can impair the quality of life in an adjoining state.

In turn, uncompensated negative external effects can only exist if property rights are not fully assigned.

If the ownership of pollution is assigned to the polluter, then the polluter must bear responsibility for the resultant costs. The "polluter pays" principle was derived from the seminal 1932 work of the Cambridge economist Arthur Pigou.

In essence, the principle holds that a tax, equal to the social cost of the pollution created, should be levied on the offenders.

Two effects follow. First, the tax adds explicitly to production costs and, given diminishing returns to scale, this will cause the level of production - and hence the extent of the pollution caused - to be reduced. Second, the tax revenues generated can, in principle, be used to compensate those who suffer the effects of pollution.

A carbon tax is an example of the polluter pays principle in operation. It is levied on the carbon content of fossil fuels to offset the effect of the carbon dioxide they produce on the warming of the atmosphere.

However, while the polluter pays principle is analytically straightforward, measuring the scale of pollution, estimating its environmental impact, framing and enforcing the taxes required as a result are no easy tasks.

Thus, for over a century, economists have pointed to a loss of human welfare caused by pollution. More than that, their work has provided concrete foundations for the development of practical environmental taxes.

What then of the charge that economists suffer from "growthmania", as EJ Mishan, himself an economist, put it in the 1960s?

There are two issues of relevance here. First, economists measure things; that is their job. But they can measure only those things that can be counted and the things that can be counted are usually denominated in money. Second, almost all economists want to make the world a better place, reflecting the discipline's origins in moral philosophy.

But for most of its history, the behavioural assumptions underpinning the vast superstructure of highly sophisticated economic analysis have been weak to the point of naivety. It is an over-simplification, but not too much so, to summarise the traditional behavioural assumptions of economics as "more is better". Economic growth provides more, in terms of higher material living standards, so it must be better.

This assumption has been challenged by the fact that economic growth continually disappoints. Human happiness cannot be shown to rise in step with the growth rate (though the relationship may be asymmetric).

Amongst the explanations advanced, three appear compelling.

First, economic growth itself may be much lower than suggested by conventional national accounts, which add up the goods produced in an economy but do not subtract the "bads" such as pollution, congestion and commuting time. Some economists have sought to tackle this problem by integrating environmental accounts into conventional national accounts. Typically, such measures of economic welfare show composite growth rates at between half and two-thirds of the official growth rates.

Second, in rich societies, increased consumption of goods and services by individuals may not lead to the satisfaction of their wants, but merely to their refinement.

Third, there is no inherent tendency for economic growth to solve distributional problems and distribution matters. A person's place in the pecking order is often more important to their sense of wellbeing than their absolute standard of living. In 1998, students at Harvard were asked whether they would prefer to earn $50,000 a year while others earned an average of $25,000 annually, or to earn $100,000 a year while others earned an average of $250,000 annually, with prices being the same in both cases. The majority of the students chose the first option.

It is a measure of how far economists have travelled in recent years that the source of the example quoted above is a 2005 book by the labour economist Richard Layard, called Happiness - lessons from a new science.