Friday, October 8, 2010

Added Value

I was recently reminded of Adam Smith's “invisible hand” of the market, which is supposed to enable society to benefit from people acting purely based on their economic self-interest. The point of the comment was that if businesses use the so-called “triple bottom line,” then they can have economic growth that benefits society and the environment.

Traditionally, the value of a business is measured in monetary terms as the difference between what it owns and others owe it (its assets) and what it owes (liabilities). This is its economic value, or “bottom line.” As people have become more concerned with the social and environmental consequences of economic activity, some businesses have adopted ways of measuring their value in those terms, creating a bottom line for each. Most recently, computer databases have enabled businesses to begin to assess the economic, social, and environmental impacts of nearly everything they produce (“life cycle analysis” using “ecological intelligence” as an application of “ecological economics”).

For a business to survive, its economic value must either be positive, or reliably growing in that direction. To be successful, its value must be growing all the time, preferably at an exponential rate. The most common mechanism for growth is profit.

Profit is simply the difference between price and cost for what the business sells. It represents, in an ideal sense, the intrinsic value that the business adds to what it purchased to create its products or services (including its “overhead” -- such as facilities and administration). In practice, the business charges a certain price, and its customers either agree or bargain for a different price, thus setting the amount of added value. The business can increase its profit by adding quality (that the customers are willing to pay for), or decrease its costs, or both.

To continue growing, businesses will invest part of their profit in creating new things to sell, increasing the value of what they already sell, reaching more customers, or investing in other businesses that are growing. Some of the rest may be kept in reserve in case of unforeseen cost increases. “For profit” businesses will distribute any remaining profit to the business owners as a reward for success (“nonprofits” invest all their profits in the business).

If social value and environmental value are held to the same standards, then a business must presumably demonstrate that they are increasing as well. Unlike economic value, however, they are external to the business, and considered part of the “commons” available to everyone (a business can't own part of a society -- we don't have slavery -- and ecosystems provide services to the entire planet). Theoretically, the impacts of business activities on society and the biosphere could be measured and converted to economic equivalents (so all three values could be reasonably compared), but because the business would be unable to either own or “spend” the two of them, there would be no way to directly use any value gains to grow the business.

A more practical approach, as I've discussed elsewhere, is to assess the social and environmental impacts in the determination of the (economic) price of products and services. Net social and environmental gain could be factored into the added value, and net losses would be factored into the cost. For this approach to work, however, every business would need to adopt the same standards, and it would need to be enforced by an outside entity to avoid cheating. It would also have to be affordable to everyone, from the smallest to the largest business, so the cost of value assessment would probably best be administered in the economic commons, a role currently held by government, which fortuitously is also the protector of the social and environmental commons.

In Adam Smith's day, when people did something, they got direct and immediate feedback about its effects from their (small) communities and local environment. Technology in the 1700s was limited, so they had limited influence that transcended their awareness. Being bound tightly to a community, a person's self-interest was generally in the community's self-interest; this was the essence of the “invisible hand.” Such communities are hard to find now, and feedback from our actions is consequently optional and abstract. Our technologies are so powerful that we can individually affect the world's climate, yet our instincts and knowledge are in some important ways more limited than they were centuries ago: many of us don't know each other, or know Nature, at the visceral level where our humanity still lies (albeit in an increasingly dormant state). We can no longer depend on the invisible hand because we've nearly destroyed it.

Can we create a “visible hand” that is as reliable and accurate as direct experience once was? If we do, how might businesses react if their profits are eaten up by their social and environmental costs – a very real possibility, especially as we simultaneously approach the limits to our natural resources and burn out our human resources in the pursuit of relentless, exponential growth? How would we want them to react?

Arguably the vast majority of environmental damage we cause comes from making resources unavailable to the rest of the biosphere, which is a key activity of our economy. Habitat loss (paving, mining, or building on land used by wildlife), invasive species (reducing biodiversity by monopolizing resources), and pollution (making water, air, or soil toxic) are among the top causes of species loss.

We also restrict use of resources among ourselves. This virtually defines the term “ownership,” and it is one of the main sources of both violent and nonviolent conflict among people. The worst consequences have been alleviated by elaborate social organization, not the least being our economies themselves. When resources become scarce, we either move, or improve extraction and transportation technologies; but that's becoming rapidly harder to do. In times like these, warfare becomes economically more viable, as groups attack other groups to get their resources (note the invading economy's social value metrics would need to be drastically re-calibrated to avoid a major loss for its military contractors).

If the resources we used were renewable, reusable, or both, we didn't use them faster than they could be replaced or recycled, and other species weren't deprived of what they needed for survival, then at least our environmental impacts would disappear, along with our resource crisis. Substitute “people” in the last sentence, and we would make a dent in the social problems, with the minor modification that resources would be effectively on loan rather than subject to permanent ownership.

Before civilization, we depended on what Nature provided, and met all of these conditions. We also didn't live as long, and ended up being “recycled” into the biosphere ourselves. Almost everything we've done since then has been a departure from that lifestyle, and due to the damage we've inflicted on the world's ecosystems, we may not be able to return to it anyway, at least for a long time. Finding equivalent alternatives is probably our best option, especially if we want to retain something like our current life expectancy, but it will require much more than tweaking corporate balance sheets and product labels. At a minimum, we need to totally restructure our society. And time is running out.


Anonymous said...

I think it is time for non-economists to evalute our economic systems. I was also intrigued by Smith's Invisible Hand and wrote EcoCommerce 101 - a version on how the agro-economic system would function sans externalities.

BradJ1001 said...

Arguably, if it weren't for "do gooder" activists, issue based non-profits, and government-funded research, we probably wouldn't have even the modest demand (market signal) for "green" products and services currently in the market. This is part of the "feedback" I discussed. But because most supply chains are too complex to investigate, customers are still largely dependent on the honesty and integrity of the sellers in reporting the way they meet these new desires. Even if everyone, including businesses, were honest and rational (and empirical evidence, through the study of behavioral economics, is revealing they're not), there would still be immense distortion in making buying decisions through price and what information can fit on a package. This is because of the inevitable loss of useful information caused by reducing a large number of dynamic variables (especially non-linear ones) to a snapshot of the values of a handful of "representative" ones.