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A N A N A LY T I C A L F R A M E W O R K F O R I N C LU S I V E G R E E N G R O W T H

BOX 1.2

An economic framework for green growth

Classical growth theory (Solow 1956) assumes that output (Y) is produced using technology (A), physical capital (K), and labor (L). The relationship can be written as follows: Y = f (A, K, L). Growth in output results from increases in production factors (physical capital and labor) and productivity, which rises as a result of technological change, including changes in organization and practices. In this approach, the environment plays no productive role. The idea that economic production depends directly on the stock of natural resources and the quality of the environment—that is, that the environment is an argument in the production function—has been around at least since Malthus (1798). It was further developed in the environmental economics literature that took off in the early 1970s. In this approach, the environment becomes “natural capital,” an input in economic production and growth. The production function can thus be rewritten as follows: Y = f (A, K, L, E), where E represents the environment (natural capital). To analyze the effect of green growth policies, however, growth models need to be modified to incorporate market failures and the fact that the economy is not at its optimal equilibrium. A fi rst modification replaces the production function with the production frontier—the maximum production level possible with the available technology, physical capital, labor, and environment, assuming maximum efficiency. Actual production is given by Y = y f (A, K, L, E),

growth, because a higher production level increases income and savings. Where growth is limited by investment opportunities, it will fail to boost growth, because institutions are not in place to allow investors to benefit from their investment revenues. Where people are engaged in low-return activities, a limited increase in the production level may improve welfare but will not spur economic growth,

where y (a value between 0 and 1) measures the efficiency of the production process. A second modification introduces PE , which can be thought of as the effort dedicated to environmental policies: Y = y (PE) f [A (PE), K (PE), L (PE), E (PE)]. In this case, environmental policies can create synergies with economic output by increasing productive capital (K, L, and E), improving effi ciency y , and accelerating technological change by increasing A. Ultimately, it is welfare that matters, not output. This means that the model needs to account for the impact of output on welfare (or utility, U). As investment does not increase welfare directly, utility can be modeled as depending only on the current level of consumption, C, plus the direct effect of the environment, E: U = u (C, E). In practice, environmental policies can affect utility directly (positively or negatively), with effects that are not mediated by aggregate consumption or the state of the environment such as distributional impacts or increased resilience. The utility function can thus be written as follows: U = u (C, E, PE). Distribution (how total consumption is distributed across individuals) and volatility (how total consumption is distributed over time) affect welfare and can be influenced directly by environmental policies. Everything else equal, many people favor stable consumption patterns and lower consumption inequality; the utility function can thus include an aversion for risk and inequality. Sources: Hallegatte and others 2011 and World Bank.

because these economic activities do not generate sufficient returns to allow households to save and accumulate assets. A key question in this framework is the extent to which production factors are complements or substitutes. If they are complements (or weak substitutes), protecting the environment is necessary to maintain economic production. If they are substitutes, in

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Inclusive Green Growth  
Inclusive Green Growth  

As the global population heads toward 9 billion by 2050, decisions made today will lock countries into growth patterns that may or may not b...