ECOLOGICAL

ECONOMICS
ELSEVIER Ecological Economics 10 (1994) 125-147
The role of thermodynamics in the study
of economic and ecological systems
Shmuel Amir
Quality of the Enrironment Dicision, Resources for the Future, 1616 P Street, N. W.. Washington, DC 20036, USA
The Department of Applied Physics and Mathematics. Soreq Nuclear Research Center. YaL,ne. 70600, I srael
(Accepted 23 May 1993)
Abstract
Economic theory has always maintained that economic value is generated solely within the economy where it is
fully distributed among the factors of production before being consumed. According to this theory, the economy is
an isolated system that does not need flows to pass across its boundaries in support of its steady state (general
equilibrium). From a thermodynamic point of view this idea is unacceptable. According to thermodynamic theory,
any open system, which allows flows of matter and energy to cross its boundaries, is capable of maintaining itself in
steady state only because it transports &ue from its environment to restore the value that has been consumed
within the system and dissipated. Drawing on the analogy with thermodynamics. this paper replaces the traditional
systemic analog of the economy, which is the closed circular flow process, with the steady flow process. According
to this analog, any efficient economy is an open system both physically and economically requiring a flow of
economic value to maintain its steady state. In other words, an economically isolated system has to be inefficient and
is bound to misallocate and overuse environmental resources. Whether the economy behaves as an economically
isolated (inefficient) or open (efficient) system is an empirical question. However, if real economies are economically
open and efficient, and environmental resources are abused due to the economys unrestrained material growth,
parts of traditional economic theory, especially those related to benefit evaluation, will have to be modified. Policy
recommendations will be affected in any case because internalization. the panacea of resource misallocations. cannot
be more than a temporary solution. Instead of opening the economy, internalization encloses the harmed resource
and saves it by abusing excessively other environmental resources.
Key words: Efficiency; Environmental externality; Resource allocation; Thermodynamics
1. Introduction
The interface
economic theory
between thermodynamics and
has developed in two widely
different directions. The first direction is analyti-
cal, and it has been little explored (Davis, 1942;
Samuelson, 1983). It consists of an attempt to
expose the similarity of the theories and to delin-
eate the formal relations, in Samuelsons words,
that exist between them. Although Samuelsons
Correspondence to Israel. study succeeds in identifying analytical overlaps
0921-8009/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved
SSDI 092 1-8009(93)E0063-M
126 S. Amir/Ecological Economics 10 (1994) 125-142
between thermodynamic formalism and neoclassi- rgescu-Roegen, 1979). Thus, the question of
cal economics, it has not generated enthusiasm, whether or not it is necessary to include explicitly
debate, or an agenda of yet-to-be-solved prob- the laws of thermodynamics in economic theory
lems. Lismans investigations of this interface led in general, and in the theory of natural resource
him to doubt whether the theory of analogies use in particular, has not been yet resolved.
will still produce important or practical results Moreover, an even more fundamental question,
(Lisman, 19491, a view that is held by many i.e., whether or not economic theory disregards
economists and physicists alike (Faber and the laws of thermodynamics, has not been dealt
Proops, 198.5). with satisfactorily in the literature either.
This view, however, is no more substantiated
than the view outlined by the second direction in
which the interface between thermodynamics and
economic theory has developed. Basically this
direction consists of an informal claim that eco-
nomic theory neglects absolute scarcity as dic-
tated by the laws of thermodynamics (Underwood
and King, 1989), and disregards the laws of ther-
modynamics altogether (see e.g., Soddy, 1912,
1933, 1934; Boulding, 1966; Georgescu-Roegen,
1971; Odum, 1971; Daly, 1973). Moreover, it con-
sists of the less committing assertion that eco-
nomic theory has lost its physical and biophysical
foundations (Ayres and Nair, 1984; Faber, 1985;
Daly, 1987; Faber et al., 1987).
To put matters in proper perspective, it must
be said that nobody claims that economic or
ecological systems operate in violation of thermo-
dynamic laws. Rather, the claim is that economic
and policy theorists are precluded from suggest-
ing appropriate measures to curb the excessive
use of natural resources because in their theories
they ignore constraints imposed on these systems
by these laws. This claim, which asserts that the
explicit inclusion of thermodynamic laws in eco-
nomic theory could have generated more efficient
economic instruments, has not been left unchal-
lenged; however, both advocates and critics have
not presented their positions formally, making
them hard to judge (see e.g., Solow, 1972; Nord-
haus and Tobin, 1973; Simon. 1980, 1981). Even
Georgescu-Roegen, who is critical of the mecha-
nistic view of traditional economic theory, states
clearly that one cannot rectify the resulting prob-
lems merely by imposing the laws of thermody-
namics on the theory. Moreover, he rejects the
idea that economic value is related by a definite
law to common thermodynamic functions (Geo-
To discuss the latter question properly re-
quires one to establish a formal analogy between
the basic terms of the two theories (Amir, 1987).
Since each theory is considered sound by its own
practitioners, the analogy must be developed
while the terms of each theory are left intact. As
a starting point, this requires one to recognize the
following observations. First, although economic
theory only is explicit in assuming agents to be-
have rationally (i.e., to optimize), optimization
and thermodynamics are not alien to each other.
A well-known approach to thermodynamics de-
veloped by Hatsopouios and Keenan (1965) as-
sumes that systems undergo changes as long as a
(constrained) state function does not reach a sta-
ble position. A stable position is a time-independ-
ent state that solely determines the value of the
said function, and this value can always be inter-
preted as a minimal or maximal value of the
constrained function. Thus, although thermody-
namics is at most implicit with respect to its use
of optimization, economics and thermodynamics
are methodologically analogous. Second, prices
and quantities of commodities in economic sys-
tems are the analogs of the intensive and exten-
sive variables, respectively, of a thermodynamic
system. However, to the best of our knowledge,
no study of this analogy - including the most
recent ones (Bryant, 1982; Ayres and Nair, 1984;
Proops, 1985; Amir, 1987) - has yet been able to
elucidate fully the analogy between an economy
and a reactive laboratory beaker. The missing
link for establishing this analogy may plausibly be
that human welfare, and hence the welfare func-
tion of the economy, is a nonconserved function
(Amir, 1992a). In contrast to traditional economic
thinking, human welfare changes when an iso-
lated system, consisting of the economy and its
S. Amir / Ecological Economics 10 (1994) 125-142 117
surroundings, undergoes any economic process,
including a steady flow process.
This idea is not only plausible, it is also ex-
tremely fruitful. Whereas the welfare derived
from an economy in steady state is constant,
irrespective of the nature of the welfare function,
only a nonconserved welfare function is able to
directly measure the real value of the environ-
mental resources that are lost or damaged in
maintaining the economy in its state. For a con-
served function, whose global level is also con-
stant, this value, by definition, is equal to zero. It
is unfortunate, therefore, that theory alone can-
not determine whether the welfare function of an
economy is conserved or nonconserved. This
question is empirical. The answer to it has to be
found in the observed variables of the economy.
Fortunately, the theory predicts that the state
variables, the prices, the stocks, and the flows of
the conserved and nonconserved systems will dif-
fer markedly, and provides the equations needed
to study these differences. Moreover, the theory
demonstrates that the welfare function of any
efficient system cannot be conservative and that if
the decentralized free market economy operates
according to the rules prescribed by traditional
economic theory, it is necessarily conservative
and inefficient. This demonstration immediately
A state-dependent function is said to be conserved if it
assumes a constant value when an isolated system, i.e.. one
that does not have any interaction with its surroundings. is
undergoing a process in which its state changes. A system is
(nonkonsetved if its approach to an equilibrium state or to a
steady state, as the case may be, is guided by a (nonkon-
served function. Observe that this definition is equivalent to
the more common one that states that a system property is a
conserved quantity if it is derived by summation from the
same property of any number of separate systems, whenever
the latter are merged and isolated. Consider systems of reac-
tive chemicals that are merged into a system and isolated.
Before a chemical process starts, any extensive property of the
merged system, conserved or nonconserved, is derived by
summation from the respective properties of the original
systems. However, when the process ends, the value reached
will stay unchanged only if the property is conserved. Other
concepts and terms borrowed from thermodynamics are ex-
plained in any textbook on thermodynamics or in my earlier
studies (Arnir, 1987, 1991). Readers in need are strongly
encouraged to acquaint themselves with one of these sources.
implies that the free market misallocates environ-
mental resources by producing inappropriate eco-
nomic signals. These signals cause the L&e of
the resources lost in maintaining the state of the
economy to be higher than is necessary. Contrary
to common knowledge, even from a theoretical
point of view alone, Pigouvian taxes and other
internalizing measures cannot rectify this misallo-
cation without abusing other resources. It is a
symptom of the efficient states of the economy
that the real value of the inflows is higher than
the real value of the outflows, so that the real
transactions carried out across the boundaries
between the economy and its environment are
not balanced. Pigouvian taxes that are set propor-
tional to real values cannot be effective unless
complemented by mechanisms that will keep
monetary transactions unbalanced as well.
Furthermore, in view of the structural and
functional analogy between economic and ecolog-
ical systems (Arnir, 1987), optimization and the
ensuing valuation multipliers (biotic potentials)
will become cornerstones of efficient resource
allocation in ecological systems as well. Except
for rare occasions (see e.g., Fretwell and Lucas,
1969), the concept of the biotic potential as a
force that guides the spatial and temporal distri-
bution of biomasses is alien to ecological theory
and has never been integrated into community
and ecosystem models. In addition to providing
ecological systems with their intensive variables
(biotic potentials), our analysis gives rise to sev-
eral summary measures that characterize the state
and functioning of economic and ecological sys-
tems. Since theory alone cannot specify the exact
form of the welfare function, and no law, thermo-
dynamic or otherwise, dictates a specific objec-
tive function of a system, these measures also
should be derived from an empirically tested
function. Most measures are linear expressions,
formed by summing up products of either the
stocks or the flows of the system concerned with
their respective valuation multipliers. This makes
them look like conventional measures of the
functioning of economic systems. There is, how-
ever, one distinction. Conventional measures,
both in economics and in ecology, are derived
from an accounting system that is forced to obey
128 S. Amir/ Ecological Economics 10 (1994) 125-142
a law of value conservation, and they manifest the
principle of a balanced budget. If the summary
measures of a nonconserved system are con-
structed to be proportional to the real values, the
resulting expressions, whether they are monetized
or not, must satisfy the condition that transac-
tions remain unbalanced in steady state.
To derive the results described above, this
paper pursues the following objectives: (a) to
present an analogy between economic and ther-
modynamic theories; (b) to examine this analogy
and establish its validity for economic and ecolog-
ical analysis; and Cc) to study its implications for
the analysis of the optimal use of environmental
resources.
This paper is multidisciplinary and touches on
three different scientific fields: economics, ecol-
ogy, and thermodynamics. To help readers, it
avoids rigorous mathematical presentations and
focuses on the main issues. It is not intended to
be analytical, but to discuss the issues compre-
hensively without presenting formal mathematical
proofs.
In the first of the following sections, a formal
model of an economic (ecological) system is pre-
sented. The next section analyzes the steady state
behavior of this system and explicates the differ-
ences in the analysis between the present and the
traditional economic theories. In the last section,
the implications of this analysis for the study of
the efficient use of natural resources is discussed.
2. The model
In this section we present a model of an open
system. The model represents any economic or
ecological system starting from the individual
agent (organism1 and ending with the global
economy (ecosystem). In order to render the
analysis more accessible, the assumption is made
that the system may be represented by a general-
ized-production-, linear-activity-type model (van
Neumann, 1945; Koopmans, 1951; Malinvaud,
1953; Gale, 19601. This assumption does not re-
strict the generality of the model and the derived
conclusions.
Let there be in the system and its surroundings
Surroundings
Open Boundar!
/
,,,,,,,,,,,,, ,,,,,,,,,,,I ,,l , ,
K:CX
4
4
Yi> 0 ,
i BX -
AX : Yi<O
Fig. 1. A diagram of an economic or ecological system as a
thermodynamically open laboratory beaker.
m commodities, n subsystems and J activities,
and let us assume that J B n > m. A commodity
is a chemical compound or any mixture of such
compounds. An activity is a linear way of trans-
forming commodities into other commodities; it
may be considered to be an unscaled chemical
reaction. Whatever the system is doing must be
done by employing activities (Lancaster, 1966;
Amir, 19791, so that the term activity applies to
the exchange as well as to the production and
consumption of commodities (and services). A
subsystem may be any part of the original system:
individuals, firms, industries, economic sectors,
national economies, populations, guilds, commu-
nities, and general ecological assemblages. The
definition of the subsystems may change accord-
ing to our study goals. However, all systems and
subsystems are thermodynamically open, and they
exchange matter and energy with their surround-
ings at the same time that they operate activities.
To simplify notation, we may henceforth disre-
gard the subdivision of a system into its compo-
nent subsystems. Alternatively, we may assume
that each subsystem has only one activity.
Let Xi be the level of the jth activity, b, be
the amount of commodity i produced by the jth
activity (per unit of time and activity), and aij be
the amount of commodity i consumed by the jth
S. Amir / Ecological Economics 10 (1994) 125-142 129
activity (per unit of time and activity). Denote by
Y (YE Em) the flow of commodities associated
with the system (Fig. 1). If Y. > 0, the ith com-
modity flows out of the system. If Y < 0, the ith
commodity flows into the system. Let d K (d K E
E) denote the change of the stocks of the sys-
tem during the production period. dKi is positive
for an increase in the ith stock and is negative for
a decrease. Thus, K, denotes the stock of the ith
commodity held within the boundaries of the
system.
Viewing activities as chemical reactions, in
which products (outputs) are formed from reac-
tants (inputs), we associate the inputs to the
reaction with the stocks K, and the inflows -Y-
during the period of reaction dt. Hence,
AXdt< -Y- dt+K,.
(I)
Similarly, we associate the outputs with the final
stocks K, +d, and the outflows Yc. Hence,
BXdt>Y+ dt+K,+,,,,
(2)
where A and B - the input and output matrices,
respectively - are m x .I matrices and X E E/,.
Recalling the definition of dK and dividing
the equation by dt, we derive a fundamental
expression for the operation of the system.
BX-AXa dK/dt +Y,
where Y = Y+ + Y-.
(3)
An activity cannot be operated in a vacuum.
Stocks of commodities are needed as well as
flows. Let cij be the amount of commodity i
needed per unit of process j. We write:
CX<K,
(4)
where C is an m XJ matrix. Constraints like Eq.
4 are going to be our working constraints. How-
ever, since a solution to the allocation problem
never contains more activities than commodities,
we do not have to consider the question of capital
Obviously the definitions of the stocks and the boundaries
are intertwined. For example, for a closed economy that
includes the consumer sector within it, the stock vector must
include human capital in addition to conventional capital. If
some environmental resources have been internalized into the
economy. their stocks have to be included in this vector as
well.
allocation among activities or what happens if the
number of activities is higher than the number of
commodities. We can solve the allocation prob-
lem in three ways: we can make an allocation as
in Eq. 4; we can decide to make no allocation of
capital among activities because all activities use
a single vector of available stocks; or we can solve
an optimization problem to assign activities to
commodities (Dorfman et al., 1958, p. 356).
Welfare (health and integrity in the ecological
terminology) is another element that character-
izes a system. It is the entity believed to be
increased by the mechanism that generates the
situation of an as-if maximization, e.g., free com-
petition or (natural) selection. It is important to
realize that welfare is a state function that has to
depend on the system stocks, but is not necessar-
ily a thermodynamic function. 4 In fact, any state
function may become a welfare function, pro-
vided maximization of this function does not give
rise to behavioral patterns that contradict ob-
served behavior. Observed behavior, not theory,
can test whether a proposed function is an ob-
jective function.
Assume the system has a function W (for wel-
fare) defined on the stocks of commodities and
possibly on time.
W= W( K, t).
(5)
Welfare is not necessarily a real entity that exists
independently of other material entities. Much
like accounting money and energy, it may be an
abstract entity used to value other entities. It is
important to bear this fact in mind because it is
extremely difficult to avoid common usage, which
envisages welfare and energy to flow like matter.
Welfare may increase or decrease when the sys-
tem passes from one state to another, but, being
Ideas vary as to what represents welfare in nature. Sugges-
tions include biomass (Odum, 1969: Reichle et al., 1975;
Whittaker. 1975; Hannon, 1976), retained energy (Hannon,
1979), power (Odum and Pinkerton, 1955; Odum, 1971). free
energy (Lotka. 1956), or ascendancy (Ulanowicz. 1986). The
situation is no less involved in economics where several candi-
dates exist, such as capital, gross or net national product,
utility, and social welfare.
4 A flow-based definition of Wf K, t) is given below in Eq.
(18).
130 S. Amir / Ecological Economics 10 (1994) X25-142
merely an accounting medium, it cannot flow
across the system boundaries.
Assuming W is linear homogeneous in K, we
can write W = c~(t)p(X t)K where it is assumed
that the derivative of W with respect to Kj is
ap, E E. The net gain in welfare (profits or sav-
ings), 7r, may be written as follows:
x( K, t) = dW/dr = 6W/6t + n(d,dr)( xp;K,).
(6)
where SW/St = &pK and & = da/dt. Eq. 6 be-
comes:
+ C pi + C(6p,/6Ki)K, ii,
I
1
I
)
(6)
where 6, = 6p,/6t is the partial derivative of p,
with respect to t and K, = dK,/dt.
3. Steady state analysis
This section is divided into two parts. In the
first part, the optimality criterion of the present
model is presented, interpreted and analyzed. In
the second part, the process of discounting is
introduced and its role in regulating the activities
of the system is delineated.
3.1. The optimafity criterion
In steady state the vectors dt )p( K, t) and Y,
of intensive variables and flows. respectively, are
time independeat, and the stocks K stay un-
changed, i.e., K = 0. Every commodity must be
located somewhere, either in the system or in its
surroundings. If it is placed only in the system, it
is part of the stock vector K. Hence, in steady
state it must be completely recycled. If it is placed
only in the surroundings, it enters into the system
or leaves it as a flow, which is included in the
flow vector Y. Hence, in steady state it will flow
at a constant rate in one of two directions, into
the system or out of it. If stocks of a given
commodity are available both in the system and
in its surroundings, in steady state there is no
change in the stock within the system, but possi-
ble losses or gains may be balanced by flows that
cross the boundaries rather than by the stock
being fully recycled.
Consider an unconstrained change of W(K t>.
Welfare will be time independent, assuming any
path is possible, if the net gain r is maximized,
and the maximum of r, i.e., r* equals 0. Since
d = 0 in steady state, r is given by Eq. 6 as
follows:
rr(K, t) =6W/St+&;;K;
=(Y{(cS/(Y)~K+J?K}.
(6)
A change in welfare can be brought about in
two ways. First, it can be brought about by earn-
ing income I, i.e., an increase in welfare mea-
sured by the accounting value of the outputs and
including the revalue of the stocks and the value
of the outflows. Second, it may be brought about
by incurring costs E, i.e., a decrease in welfare
given by the accounting value of the inputs. Thus,
we define:
dW=rrdt=Idt-Edt
=(r(pBX dt -p/IX dt).
(7)
The maximization of WCK, t) can be broken
into two independent problems: a linear pro-
duction problem and a nonlinear consumption
problem. The production problem is that of
maximizing the value of the net product. Due
to Eqs. 3 and 7, this product is given as follows:
p,BXdt -p,mdt =~,+dtK,,dr -P,K, +P,Y dt,
(8)
where pr and prtdl
are the price vectors of the
current and the next period, respectively. Assum-
ing plcdr =p, + dp, =p + dp, Eq. 8 may be writ-
ten as follows:
pBX-pAX=;K+p@+Y).
(8)
Observe that the right-hand side of Eq. 8 is
S. Amir/ Ecological Economics 10 (1994) 125-142 131
equal to i~( 4 t )/a(t), provided p does not de-
pend on K and 6W/6t = cipK =crpY.
The generalized production problem be-
comes the following:
max
X,K,d+Y
{jK+p(i+Y): BX-AX&+Y;
CX< K}.
(9)
An equivalent, but more insightful, way to pre-
sent the same problem is to consider the follow-
ing pair of problems consisting of a primal prob-
lem:
-
min {-~~K-~Z?:(B-A)X-I ?~Y;CXGK)
X,K,I?
(10)
and a dual problem:
- max{uY: (B-A) u <Cc; L Q -8; u >p},
u,c
(11)
where (B -A) and C are the transposes of
B-A and C.
The duality theory of linear programming
shows that if Eqs. 10 and 11 possess feasible
solutions (which we assume), they also have opti-
mal solutions X* 2 0, K* 3 0, u* a 0, and c* G
0, and the following equation is satisfied:
-fiK* -p&+=lPY.
(12)
The us and US are known as shadow prices,
i.e., !i and li are equal to the change in -bK *
-pK * given a slight change in Y, or in K,
respectively, provided the ith constraint is bind-
ing. Thus, whenever a constraint in Eq. 10 is not
binding, its dual variable (its shadow price), is
equal to zero. Whenever a constraint in Eq. 11 is
not binding, its dual variable (the appropriate K,
or X,) is equal to 0.
The problem thus far solved is not a steady
state problem. For a given K it may be worth-
5 After the paper went to press, I came to realize that this
assumption, which is very common in ecological studies but
seems restrictive for multicommodity economic models, can
be avoided if the right-hand side of Eq. 7 is redefined to read
crp((B - A)X- Y)dr. For more details and the consequences
of this modification see footnote 8.
while to choose I? f 0 and change K. However,
K is optimal when the value of net production is
maximized in steady state, and any change in K,
which normally may differ from zero because it
absorbs the difference between (B - A)X and Y,
converges to zero. When this happens, the follow-
ing equation is derived:
-;K*=u*Y.
(12)
This equation is a basic result in need of
interpretation. It says that the value of the
stocks is equal to the value of the flows. Since
our description of the system has taken into ac-
count all possible stocks and flows, there exists
no real entity that can be called value. Thus,
the original ps, the fis, the us, and the LS are
accounting prices. They express values in terms
of an abstract ghost money that exists every-
where and nowhere (see e.g., Patinkin, 196.5, p.
15).
Eq. 12- which represents the right-hand side
of Eq. 6, provided (l/cuMW/St =u*Y>pY -
raises some questions because it apparently con-
tradicts theory both in physics and economics.
According to this equation, any change of value
within the system (the left-hand side of the equa-
tion) is matched by a difference in the values of
the inflows and outflows (the right-hand side of
the equation). Two main questions arise. First, in
steady state, when p must be constant, how can
i; (its time rate of change) differ from zero? This
question is a cardinal one tecause by assuming
that dp/dt =fi + (6p/6K)K =0 in steady state,
optimal growth theory has acted arbitrarily and
assumed that B = 0 as well (see e.g., Arrow and
Kurz, 1970, p. 66). Second, in steady state, when
any state function of the system must be constant,
how can the net flow of value u * Y differ from
zero?
Depending on the definition of value, two
possible cases exist. The first is based on the
following identity:
value = energy = real (accounting) money.
(13)
According to this approach, value is a real
thing. If it is to be equated with accounting
money, additional restrictions must be imposed
131 S. Amir / Ecological Economics JO (1994) 125-142
on the circulation of this accounting medium.
According to Eq. 12, the physical stocks within
the system remain steady. The only sources of a
possible change are the flows Y. These flows
cannot be avoided in steady state because even in
thermodynamically closed systems the flows of
light and heat continue. These two flows
have no matching stock equations because light
is derived from an external source, and heat
flows into an external heat bath. When the con-
straints of the optimization problem are satisfied
with equalities, light is completely used by the
system and any heat generated leaves the sys-
tem. However, the heat generated is not neces-
sarily equal to the light used. Light and
heat differ, and cannot be forced to be equal.
Thus, the answer must be formulated in the fol-
lowing way. If value is real, by definition, it
cannot be accumulated in or depleted from a
system in steady state (Keenan, 1941; Denbigh,
1951; van Wylen, 19.59). Hence, in a closed system
the value associated with the incoming light
must be equal to the value associated with the
outgoing heat. The extension of this answer to
any open system in steady state will simply re-
quire that the following equation is satisfied:
qY=O,
(14)
where the qjs are the values per unit of the
flows of the Ys. This equation asserts that value
is conserved, and it may be called the law of
value conservation.
If, as suggested above, u* Y equals zero, then
U* Y = qY, and the accounting medium is subject
to a global conservation law. This is shown as
follows: The amount of accounting medium in the
surroundings does not change because u * Y = 0.
Since the basic solution is efficient, all the 5,s
have the same sign (Dorfman et al., 1958), i.e.,
they must be equal to zero. Therefore, the p,s
and the amount of accounting medium within the
system do not change either, i.e., the accounting
medium is globally conserved.
There are two problems with this solution.
First, Eq. 14 is not part of the optimization prob-
lem in the first place because we have taken into
account all observed flows and stocks, and we
have not been able to observe any (real) flow of
value independent of light, heat, and mat-
ter. Second, there is no law whatsoever, physical
or otherwise, forcing u*Y to take certain values
in the steady state. If u * Y f 0, not all the 5s can
be zero. Actually, since the basic solution is effi-
cient, they all will have the same sign, either
positive or negative.
As a result of the optimization problem and
the fact that d = 0, W(K, t 1 is constant in steady
state. Hence, if W(K, t) is not a conserved func-
tion, u *Y differs from zero, and global changes
in welfare, given by u*Y, must be attributed to
changes that have occurred in the surroundings.
This implies that the fact that W( K, t) is constant
in steady state has nothing to do with whether or
not it is a conserved function and U* Y = 0.
Therefore, it is important to note the following
points. First, steady states satisfying the condi-
tions u* Y # 0 and fi # 0 cannot be excluded.
Second, the function U* Y measures the net real
(welfare) L-due of the resources that are taken
from the environment or disposed into it in sup-
port of the steady state, i.e., u*Y is a measure of
the environmental cost of maintaining the econ-
omy in steady state. Third, if W(K, I) is a con-
served function, u*Y is equal to zero, and no
environmental cost is involved with maintaining
the economy in steady state.
As a consequence of the preceding discussion,
W(K, t) will be a conserved function and will be
called an internal energy-like function if 5 = 0,
i.e., U* Y = 0 in steady state. If welfare is con-
served, we face a particular case of the first law
of thermodynamics. This law says that, with re-
spect to energy-like functions, any change within
the system (whether or not the system is in steady
state) is matched by an opposite change in the
surroundings (cf. Eq. 12 after a zero is substituted
for 8). However, Wt K, t) does not have to be a
conserved function. If it is not, fi f 0. In this case,
W(K, t) is called a free energy-like function (i.e.,
in steady state u * Y G 0 whenever p > 0, and u * Y
2 ;O whenever p < 0) or an entropy-like function
(i.e., in steady state u * Y G 0 whenever p <0, and
u * Y 2 ;O whenever p >0). Note the essential role
of the qualifier like, which has been added to
signify that W(K, t) does nor have to be a ther-
modynamic function.
S. Amir/ Ecological Economics I O (1994) 125-142 133
If u * Y # 0 we face the second case:
value = free energy
= abstract (accounting) money.
(13)
Since the accounting medium is a ghost, noth-
ing real is changed in the system, which is claimed
to be in steady state. However, we still have to
reconcile two facts, i.e., that 6 may differ from
zero whereas p is a constant. The solution is
found in the process of discounting.
3.2. The discounting process and efficiency
The present model departs from the main body
of economic theory in not assuming that INK, t)
is a conserved quantity, This departure allows 3
to differ from zero, and the last assumption keeps
Eq. 12 from becoming trivial. Hence, Eq. 12 can
be used as a single constraint, summarizing the
productive side of the model, in the maximiza-
tion of W(KJ t). The other part of the problem,
the consumption problem, can now be written
as follows:
The first-order necessary conditions for a max-
imum are:
mF{W(K, f): fiK<rn),
(15)
where welfare is a free energy-like function, i.e.,
p>O,and m= -u*Y>O.
6W(K, t)/6Kj--~8~~0, i= l,..., m,
( 16)
where u > 0, the Lagrange multiplier, is equal to
6W(K, t)/6m.
Solving these equations for the K,s and C, and
comparing the result with the definition of the
p,s and with the value equation, the solution
can be closed, provided the following equations
are satisfied:
O<ap,(K, t) <a(K, m, t)i;i(K, m),
i= I ,..., m,
(17)
where K, =0 whenever the right-hand side of Eq.
17 is satisfied as a strict inequality. Thus,
T(K, m, t) =a(K, M, t)/(Y(t)is the turnover time
(period of production, in economic terminology),
and p, is the present value of Bi, with /3(K, m, t>
= l/r(K, m, t) playing the role of the discount
rate. In this way the physical observation that
reveals the same p every day also provides the
monetary rule that Malinvaud (1953) shows is
needed for a discount rate /3(K, m, t) to appear.
According to this rule p, =pexp( j/?(K, m, t )dp).
At the same time, this expression explains how p,,
the present value of ci, is time independent
whereas 8, f 0.
To better see how the mentioned departure is
made possible, we have to consider the dynamic
version of the model. Up to this point, we have
not committed ourselves to any specific welfare
function. At present we will assume that welfare
is given as the accumulation of the following
future flows:
W( K,, to) =max/- eePp( K, t)Y dt.
tu
(18)
Maximizing the modified current value Hamil-
tonian of this problem as given by Eq. 9, the
first-order necessary conditions are:
p(K, t) -u=O,
(19)
5 = --L=/~P - (6p/SK)I ?-p( B -A)C-
In steady stat:, Z? = 0 and da(t)p/dt = a(fi -
pp + (6p/6K)K) =O.Eq. 20 becomes:
- Y( 6p/6K).
(20)
In view of Eq. 19, u is replaced by p(K, t) in Eq.
20.
-i;,/p,+p=(l/pj)6pY/6K,=0, i=l,..., m.
(21)
This establishes the equality of Eqs. 17 and 21,
and shows the rate of change of the individual
unit values to be equal to the discount rate. It
also explains why the present result differs from
the one derived in economic theory, i.e., p =
(l/p,MpY/6K,. This result is a necessary out-
come of Eq. 21 after traditional economic theory
has assumed, with no justification whatsoever,
The rationale behind this functional expression is best seen
if boundaries are placed between the productive sector of the
economy and the consumers. Then pY imitates a traditional
measure of temporal utility that includes consumption on its
positive side and labor on its negative side.
134 S. Amir/Ecological Economics 10 (1994) 125-142
that fi = 0 in steady state and W(K t) is a con-
served function. 7
By assuming that fi = 0 in steady state, eco-
nomic theory has ignored the possibility that 5 # 0
and that W(K t) is a nonconserved function. It
also has discounted the possibility that the follow-
ing assumption, which now we are ready to make,
is always true, and can become a law of the
economic process. For any change of state of the
economy (ecosystem) and any nonconserved wel-
fare function W( K, t 1, the weak inequality fiK >0
is always satisfied. Moreover, an equality sign is
possible only if the process that leads to the
change of state is reversible, i.e., is completed
without leaving any change in the surroundings. s
In the present context of a steady flow process,
this assumption means that while the value of the
outputs is already embodied in the value of the
inputs for a maximizing function, the value of the
inflows is higher than the value of the outflows
for any real process. In the more general case of
a growing open system, this assumption implies
that the real value of the resources withdrawn
from the environment is always higher than the
real value of the stocks incorporated in the sys-
tem during the same period. Equipped with this
plausible assumption. we turn to the last stage of
our analysis.
One question still remains: What is the physi-
Other substantial parts of economic theory also maintain
that economic welfare is a conserved quantity. No basis or
justification for this assumption i\ ever provided. In general
equilibrium theory, the assumptton IS made that all inputs to
the production process are variables. i.e.. the stock vector K
for the productive sector is equal to zero. Since the economy
must contain some stocks to operate. as is evidenced by the
initial holdings of the consumers. but the budget constraint
does not include a term for fiK. the assumptton is. again. that
c = 0, implying welfare to be a conserved function. The claim
that value is a conserved function is explicitly made only in
one place (Dorfman et al.. 1958, p. 322). where, surprisingly,
the value of the economy has become a constant irrespective
of its state. which might be growing. declining. or remaining
steady. Very recently, this claim has been repeated with
regard to the same van Neumann economic growth model
(Samuelson, 1990), which essentially describes an isolated
economy in no need of any surroundings for its growth and
survival.
cal meaning of the discounting process. This
question has been pondered by Amir (1983).
Consider the economy or the ecosystem as either
a cyclic engine or a steady flow process. In steady
state any sequence of chemical reactions can be
viewed in either way (Denbigh, 1951). The econ-
omy produces outputs from inputs and returns to
the input stage after the outputs are consumed.
During this cycle the economy is absorbing mate-
rial resources and light from its surroundings.
The material resources become different material
resources, and the light is emitted as heat. Effi-
ciency is a measure of the initial value that has
been transformed successfully into the final
value along the cycle. It is defined as E =
-uy+/uy-= (fiK+ uu-)/uY-= 1 +BK/uY_.
The efficiency of the system increases with the
length of the cycle. The exact dependency is not
of any importance, but its extent is limited be-
cause j? 2 0. Thus, r( K, m, t) =p, /8, < m and E
< 1 for any real economic process. To increase
efficiency, fiK must be decreased without a con-
comitant decrease of uY-. Since a decrease in K
will affect SK and uY- similarly, the effective
route is to decrease i; by slowing down the pro-
Although several equations have to be slightly modified if
the assumption of footnote 5 holds. this law and other basic
concepts presented in the paper remain valid. To see this
point, note that Eq. 8 would have to be rewritten as
a,p,BX df -rr,p,AXdr
,a
r+JlPl+dr
K
r+*r -Y,P,K, +a,p,Ydf
or
apBX - apAX - apY >6pK +a;K +npd.
making the expression c&p +ab)K +apti + Y )- crp(B -
A)X the objective function of Eq. 9. Eqs. 12 and 12 become
(Gp+a;)K* +apt?* =up(B-A)X-u*Y and ap(B-
A)X * =u * Y respectively. However, the original equations
remain valid because once Eq. 16 is reached. i; has to be
defined as p(A - E)C-. Hence, apt A - B)X =abK and
regarding ;K >0 to be an expression of the law of the
economic process is equivalent to claiming that p(A - B)X >
0 serves this purpose. Given the last equality, the definitions
of conserved and nonconserved functions, the discussion on
the efficiency of the economic process, and other conclusions
are left intact, although the integrand in Eq. 18, which now
should be read e -@p(K rH(B - A)X - Yldr, and Eqs. 20
and 21, which now include dB - A)X(Sp/GK) as an addi-
tional term, have to be inconsequentially changed.
S. Ark/Ecological Economics 10 (1994) 125-142 135
o j ; turnovertlme
Fig. 2. The optimal period of production of an open system in
steady state.
cess. This is achieved by increasing the complex-
ity and roundaboutness of the process and by
widening its capital base (Fig. 2). At any given
moment, however, the extent of roundaboutness
is constrained by the rate of time preference.
Since it is assumed that the present is preferred
over the future, the rate of time preference j? is
positive. According to Eqs. 17 or 21, the cycle
length (turnover time or period of production) is
constrained at the optimum point because
7(Ic m, f) must equal l/p for maximum effi-
ciency to be achieved. At the point of maximum
efficiency, -fiK is minimized, 14Y is maximized,
and -J ?K * = u* Y. Higher efficiencies are ob-
tainable only if the rate of time preference is
somehow decreased. This will allow slower pro-
cesses - which are more complex, roundabout,
and capital intensive - to take place.
It is important to understand two points. First.
the moment we realize that W(K, t) may be a
nonconserved function, we must also see that the
way the sum -fiK + u* Y is divided between its
) Based on this fact, some may argue for a biological or
perhaps a thermodynamical basis for time preference, but this
is not what has been meant by claiming that economic theory
ignores the laws of thermodynamics.
terms -5K and u*Y is path dependent whereas
that sum is always equal to zero in steady state.
Given the stocks of the economy. the economic
process can be carried out in various ways, most
of which are inefficient. The efficient way equates
the rate of time preference p to p(K m, t).
p(K m, t)= 1/7(K, m, t), and dK, m, t) is the
variable that guides the response to the physical
environment. 7( K, m, t) is determined independ-
entZy of j3. It is the average time it takes for a unit
of Y- to circulate in the system until it shows up
as a unit of Y+ - that is, the period of production
of the economy operating as an irreversible steady
flow process. Second, the economy is not merely
a reactive beaker through which a steady flow
process is forced, and W(K, t) is not a simple
thermodynamic function. Hence, the optimum
reached is of a social (ecological), rather than of a
physical, importance, and Prigogines assertion
(1961) that thermodynamic entropy production
is minimized in steady state is unlikely to be
applicable in the present context. However, with
respect to the welfare function that guides the
economy in question, it can be said that, at the
optimum, the loss of welfare is minimized, pro-
vided welfare is a nonconserved function.
We now turn to an examination of the neces-
sary role played by the last condition which as-
sumes welfare to be a nonconserved function.
Assume for a moment that W(K, t) is a con-
served function. This assumption implies that 6
= 0 and u*Y = 0. The only way to satisfy Eq. 17
with p > 0 is to let p(K, m, t>approach zero and
dK, m, t) approach infinity. Assuming the pre-
sent is preferred over the future, /3 > 0, and Eq.
21 is satisfied by equating p to (~/u,MK*Y/~?K,
for every i. This means that U* Y is not a maxi-
mum, l/p does not satisfy Eq. 17, and the result-
ing state is not efficient. Moreover, as the follow-
ing argument shows, this state is also intertempo-
rally inefficient.
The only way to satisfy both Eq. 17 and Eq. 21
when WC K, t) is a conserved function is to dis-
miss time preference and to equate p with zero.
If W(K, t) is conservative, holding a positive rate
of time preference is myopic. This rate can be
forsaken with no welfare loss. No sacrifice is
incurred by anybody if p is reduced to zero and
136 S. Amir / Ecological Economics 10 (1994) 125-142
the economic process is slowed down. As this
process continues, u * Y is maintained at its zero
level, and K and W(K t) can be increased at no
social cost until B = B( K, m, t) = 0 and T( K, m, t >
approaches infinity. When the final state is
reached, the transformation of Y- to Y+ is
accomplished by passing from one activity to an-
other along a definite sequence in a manner
similar to that suggested for a sequence of heat
engines by Ondrechen et al. (1981). Since each
activity takes an infinite amount of time to be
completed, the resulting process is reversible and
does not affect the systems surroundings. No loss
of welfare is incurred, since no free energy-like
entity is consumed and no entropy-like entity is
generated and dissipated. When the cycle is
completed, not only the internal energy-like en-
tity, but any value function is globally conserved.
Given this situation, U* Y = 0 and 6u*Y/6Kj =0
irrespective of the welfare function. In the my-
opic case, which is identified with the reversible
and unrealistic case. conservative and nonconser-
vative criteria coincide and the resulting unit
values are proportional.
Real processes are finite. and the activities in
the said sequence must be completed in a finite
time. Moreover, in the belief that real sacrifices
are involved, i.e., that II* Y is not constant and
that it may have to change as the process contin-
ues, people will stick to their temporal prefer-
ences which are represented by B > 0. In this
case, true welfare is a nonconserved function.
However, due to Eq. 21. d,/p, =PC K, m, t) =p,
and the turnover time T( K, m. t). which is de-
rived from Eq. 17. equals l/B. To satisfy Eq. 21
with i;, = 0. the average period of production in
the case in which the welfare function is con-
served is defined as 1 /B. Since (l/u* )
6u*Y/6K, = 0 in one case and (l/u,*)
Su* Y/SK, =/? >0 in the other case, the two
steady states. the one guided by the noncon-
served function and the one guided by the
conserved function, differ but share the same
period of production. Hence, in the initial state,
the value u * Y as derived from the nonconserved
function is not maximized, -fiK * is not mini-
mized, and a process can be found that allows the
production period to remain unaltered while the
flows decrease and the stocks increase. This
means that the initial steady state is again in-
tertemporally inefficient. Assuming that the
economy behaves efficiently, it cannot be guided
by a conserved function.
This statement does not mean that, in steady
state, mass, energy or monetary budgets are not
satisfied. These budgets are automatically satis-
fied when the steady state is reached because
they are based on the idea that the entire value
of the outputs is always incorporated into the
value of the inputs. These budgets cannot guide
the system because they satisfy the condition UY
+bK =0 identically when J? = 0, whereas the
guiding function and the unit values this func-
tion gives rise to satisfy the condition UY + {K =0
only at the optimum. Take mass for example.
Commodities are composed of other commodi-
ties, and their composition is assumed to be fixed
both in terms of the more elementary commodi-
ties and ultimately in terms of the basic chemical
elements. Hence, if 9; denotes the mass of the
ith commodity, it is fully determined by the com-
position of ith and the mass of its components.
Since chemical elements are neither destroyed
nor formed in chemical reactions, it must be true
that q(Y+dt + K ,+,,,I =TBXdt = qAXdt = q(K,
- Y-dt). Hence, q( Y +K) =0. In steady state
R = 0 and qY =0. The same argument applies
when qi measures the energy or the fixed mon-
etary value of one unit of the ith commodity.
Therefore, the equation qY =0 is satisfied in
steady state, irrespective of the value of u * Y. As
a constraint it is more than superfluous if, in
addition, u * and q are required to be propor-
tional. This requirement leads to a system that
may behave efficiently to act inefficiently.
Similarly, forcing the economy to behave con-
servatively by requiring that real (welfare) values
and exchange prices be proportional, is bound to
create inefficiencies and resource misallocations.
The behavior of the decentralized free market
economy, if in fact it follows traditional economic
theory, provides an example of this case. Con-
sider this economy when equilibrium is reached.
Economic goods are positively priced and are
circulated within the economy between the pro-
duction and consumption sectors, whereas flows
S. Amir / Ecological Economics IO (1994) 125-142 137
that either originate or end up in the system
surroundings are priced at zero. Denoting the
price vector of the decentralized economy by p
and the respective flow vector by Y , the result is
pY = 0 (y = 0 if p; > 0, and p; = 0 if yi # 0).
Traditional theory assumes that real (welfare)
values and exchange prices are proportional so
that p = u = 4~. Hence, pY= uY= 0, and the
function W(K, t) that corresponds to the process
of the decentralized market economy is con-
served. Since conserved systems cannot be effi-
cient, either the decentralized market economy
behaves as prescribed by the theory and is ineffi-
cient, or it is efficient but does not follow the
theory. If empirically the economy is found to be
efficient, those aspects of the traditional theory
that are based on the proportionality require-
ment, including most aspects of benefit evalua-
tion, will have to be abandoned or at least modi-
fied.
rium analysis will show the resulting valuation
multipliers to be the steady state (equilibrium
in economic terminology) prices of a multi-com-
ponent system. This approach is particularly sig-
nificant for studying aggregates of partially inde-
pendent open systems, e.g., natural ecosystems,
for which the existence of exchange prices or
even of thermodynamic-like potentials in steady
state is not self-evident (Amir, 1979, 1987).
4. Discussion
The observation that general equilibrium anal-
ysis is useful for the study of natural ecosystems is
important on three counts. First, in this way a
single accounting framework for the various com-
ponents of any open system can be established.
Components are integrated through the use of a
common set of valuation multipliers (the US and
LS). Although not directly observed, these multi-
pliers are computable as functions of observed
stocks and flows. In this way, the accounting
framework generates several computable ecoindi-
caters that define states of efficient resource allo-
cations, and provides policy and economic ana-
lysts with the means to estimate the value of the
natural capital (Amir, 1989).
This exposition presents the main features of Second, it provides a basis for the existence
open systems and analyzes their (moving) steady and determination of a steady state based on the
state behavior. The analysis applies to any open principle of system autonomy, which states that
system, ecological or economic, because these no subsystem can be completely controlled by
systems are analogous structurally and function- other subsystems and that any steady state, if
ally and behave similarly (Amir, 1979, 1987). In reached at all, must be maintained in a decentral-
addition, similar behavioral principles are pre- ized way. In this context, it is important to note
dicted for these systems based on the consistent the possible consequences of the alternative,
parts of two independent theories: neoclassical fully controlled, approach. To understand why
economics and thermodynamics. The analysis these consequences arise, it is sufficient to recall
shows the valuation multipliers (efficiency prices, that the immediate surroundings, i.e., the envi-
biotic potentials) to be the intensive variables of ronment as discussed in economics, are only part
economic and ecological systems. They are the of the overall surroundings of the economy. If
thermodynamic-like potenrials of the system, these overall surroundings are divided into one
and like thermodynamic potentials in physical part. called the inner surroundings, that com-
systems, they are not immutable constants of pletely envelopes the economy within environ-
nature. These potentials are present-value prices mental open bounds, and a separate part, called
that are system and state dependent and that are the outer surroundings, that does not interact
determined as-if an optimally devised plan has with the economy at all, then the flows of the
been executed by the system. Although the analy- inner surroundings are divided into two compo-
sis is based on the maximization of a single wel- nents. The first component, denoted by Y,,, de-
fare function, its extension to many independent scribes flows that cross the boundaries of the
subsystems, as was shown by Arrow and Debreu economy. The second component, denoted by
(1954), is immediate. In this case, general equilib- Y,,, describes flows that do not cross the bound-
138 S. Atnir/ Ecological Economics 10 (19941 125-142
aries of the economy. In steady state, the condi-
tion UY G 0 must be satisfied by each system with
respect to its boundaries since both the economy
and the inner surroundings are open systems.
Hence, the lower the value of uYce is at the
boundaries with the economy, the lower the value
of uYes is at the other boundaries of the inner
surroundings (uY of the inner environment is
equal to uYe, - uY~~). By definition, these bound-
aries do not have any interface with the economy
and are left uncontrolled. Since the dynamic
version of the fundamental equation of the opti-
mization problem (Eq. 12) must be satisfied by
any open system that undergoes a moving steady
state process, if not enough external stocks are
available near these boundaries of the inner sur-
roundings to make uYes sufficiently negative, the
said requirement cannot be met and the outer
surroundings start to disintegrate as indicated by
the increasing globalization of todays environ-
mental problems.
Third, since the system is less constrained when
disequilibrated, its convergence to steady state
also has to be achieved in a decentralized way.
Although the mass of a certain mineral or metal
may be held fixed at severe regulatory costs, the
alternative of maintaining mass balance over the
entire economy is not practical. Neither this al-
ternative nor any other global principle, such as
that of energy conservation, can provide recourse
against the possible breakdown of the system due
to efforts forcing it toward the steady state. Open
macroscopic systems are not subject to any
constraint other than the resource constraints
given by Eqs. 3 and 4. If these systems are
guided by nonconserved functions and are in
principle efficient, they do not have to obey the
laws of conservation by keeping their mass or
energy content constant while approaching a
steady state. In fact. they are precluded from
reaching efficient states if required to obey these
additional constraints.
Claims have been made that economic theory
disregards the energy and other thermodynamic
constraints that are placed on real systems. These
claims are unsubstantiated. UY does not have to
be a thermodynamic function. Even if it were, it
is not an independent constraint. No independent
constraints exist, other than those specified by
Eqs. 3 and 4. Other constraints are derived con-
straints. They do not have any significance with-
out the production side of the system, which
transforms the resources into a single accounting
medium.
Like any thermodynamic value function, if se-
lected to guide an efficient system. WK, f 1
must be finite irrespective of the combined size of
the system and its surroundings. Implicit in the
assumption of traditional economic theory that
no economic value flows across the boundaries
of a steady state economy is another assumption
that the surroundings are capable of providing
infinite welfare. Hence, a claim may be made in
favor of the idea that economic theory ignores
absolute scarcity (Underwood and King, 1989).
However, W(K, t> is not a real entity and, cer-
tainly, it is not an independent resource. Thus,
economic theory does not ignore either relative
or absolute scarcity as much as it is blind to the
fact that human welfare is not likely to be a
conserved function. Ignoring this possibility, neo-
classical economics explains the behavior of con-
served systems only, which are either economi-
cally isolated and inefficient or reversible and
unreal. Thermodynamics is a wider theory of
value than neoclassical economics. It explains the
behavior of any efficient system, conserved or
nonconserved. If, from a methodological point of
view, the analogy with thermodynamics is essen-
tial to the study of economic behavior, i.e., if
human welfare is a nonconserved function, it is
impossible to sustain welfare without incurring
some environmental costs (Amir, 1992b). There is
no free lunch not only within the economy, as is
recognized by traditional theory, but globally as
well. In this sense only, economic theory has
ignored absolute scarcity.
The fact that the laws of thermodynamics do
not require economic systems to be in steady
state, let alone any particular steady state, does
not mean that the analogy between thermody-
namics and economic theory is fruitless or with-
out implications for economic policy. To examine
this point we have to note differences, as well as
similarities, between the theories. The theories of
thermodynamics and neoclassical economics dif-
S. Amir / Ecological Economics 10 (1994) 125-142 130
fer in one important respect. In thermodynamics
the boundaries of the studied system are prede-
fined. In economics the boundaries are delin-
eated once the system reaches a state of eco-
nomic equilibrium. This fact bears both favor-
able and unfavorable implications.
On the positive side, it must be admitted that
economic theory is richer than thermodynamics
in providing functional rules for the distribution
of matter among component subsystems. On the
negative side, a decentralized, free market econ-
omy necessarily isolates itself, i.e., it behaves con-
servatively if it follows traditional economic the-
ory. This theory assumes that anything of eco-
nomic value is incorporated info the system, so
that whatever is left in the surroundings does not
have any economic value. Our analysis shows that
requiring real (welfare) values and exchange
prices to be proportional and insisting that trans-
actions be balanced imply that welfare must be a
conserved function. Although the economy inter-
acts with its surroundings, and the flows that
cross its boundaries are essential for its survival,
they are considered economically valueless. This
is the essence of all environmental externalities
and the crux of a common difficulty that has led
some economists to believe, without ground. that
the economy is self-sustained and others to be-
lieve. equally without ground, that the economy
has lost its (biojphysical foundations. We now
turn to address the policy implications of this
common difficulty.
Several facts are clear. First, a state of eco-
nomic equilibrium is a steady state. It is main-
tained by flows that might be thought of as eco-
nomically irrelevant but that, nevertheless. are
absolutely indispensable for the survival of the
system as an active entity enabled to maintain
well-defined boundaries around its stocks. Sec-
ond, modern environmental problems, such as air
and water pollution, deforestation, and ozone
depletion, have become part of our daily experi-
ence. Their causes are easily pinpointed to be
located in our economic activities. Although the
problems mentioned are accompanied by eco-
nomic growth and development, to the extent
that social welfare is decreased or at least is not
maximized in their presence, resources are misal-
located. Third, whether the free market is inher-
ently inefficient and operates as suggested by
traditional economic theory or is efficient but
dynamic, its capital structure is not compatible
with the external resources available. Hence. nei-
ther the lowest rate of welfare loss nor the lowest
rate of time preference has been achieved.
The realization that resource misallocations
are widespread and that they do not result from
the existence of thermodynamic constraints yet
unrecognized by economic theory leaves two
questions. First, are conventional economic solu-
tions, known to rectify resource misallocations in
general, sufficient to mitigate and redress envi-
ronmental externalities? Second, does thermody-
namics offer alternative solutions to those already
known to economists for identifying unknown al-
location problems or for dictating certain prices
rather than others?
The first question arises because environmen-
tal economics has not yet departed from the
traditional view of welfare economics, which con-
siders the environment as another sector within
the economy. Due to this view, environmental
problems are regarded as another case of the
divergence of private and social costs, a problem
that could be evaluated according to traditional
procedures and that should be redressed by inter-
nalization. However, partial internalization is not
a solution, and complete internalization, which
calls for an up front subsidization of the environ-
ment, is no more than wishful thinking. Partial
internalization is not a solution because it saves
harmed resources by abusing other environmcn-
tal resources. Following traditional theory, once a
resource is internalized by being positively val-
ued, it is eliminated from the Y vector because it
starts to circulate within the economy. the bound-
aries of which have been extended to encompass
the resource. Therefore LI* Y,, is still required to
equal to zero, and the welfare function remains
conserved. This means that the economy is ineffi-
cient and overuses other external resources.
Hence, even if traditional economic theory were
valid, and if welfare were a conserved function,
resource misallocations would have to be recti-
fied by slowing down the economic process, i.e.,
by reducing the rate of time preference and
140 S. Amir / Ecological Economrcs IO (1994) 125-142
lengthening the period of production, rather than
by internalization. lo
The only way to avoid these problems is to
recognize that the economy is an open system
from the perspective of economics as well as from
the perspective of thermodynamics. Thus, any
scientific discipline that will attempt to address
these issues of internal and external resource
compatibility will have to accept that part of the
environment that will always remain within the
surroundings as a legitimate part of its agenda.
This requires us to find a way to internalize the
surroundings into the theory without, at the same
time, internalizing it into the economic system.
The study of the economy as an economically
open, nonconserved system is a niche that has
been left vacant and is available for occupation.
For this to happen, the successful discipline will
have to depart from traditional economic and
ecological analysis. One such departure is pro-
vided by the nonconserved welfare function that
should be defined on any open system. This func-
tion is unique in its ability to measure the real
(welfare) wfue of the environmental resources
lost in support of the state of the system while the
function itself is defined solely on the systems
internal resources.
Having said this. we recognize the immense
role traditional theory has allotted to the Pigou-
vian system of taxes and subsidies in addressing
externality problems. In a utopian world, where
information is perfect and consumption and pro-
duction could be halted until markets clear,
Pigouvian taxes and subsidies might have been
the signals required to achieve efficiency, i.e., to
minimize the loss of social welfare. Our world,
however. is real, and the appropriate signals,
reflecting true social costs, cannot be derived by
anything but experience. Experience is built on
Partial internalization is a strategy widely used throughout
the biological world for coping with resource constraints. In
this case. it is highly likely that resources are overused tem-
porarily by natural populations that behave dynamically while
approaching an efficient steady state. When this steady state
is no longer a desirable goal. as is true for humans, the entire
process loses its rationale. For an extensive discussion of this
case, see Amir (1992b).
trial and error, and it affects the state of the
world and changes the appropriate signals. The
problem of the dependency of the appropriate
signal on the state of the system prevails when-
ever social and private costs diverge.
In the present instance, a more serious prob-
lem crops up. Even if the appropriate signals
could be produced by a system of Pigouvian prices,
or by Lindahls system of prices, the resulting
condition u*Y,, < 0 cannot be maintained in a
free market economy. Satisfying this condition by
making transactions on behalf of the environment
is necessary for achieving economic efficiency
whenever W(K tl is nonconserved. However, this
condition only makes explicit the real subsidiza-
tion of the economy <--u*YC; > u*YCzl, which
never could be reflected by the flows of the
competitive system that satisfy the condition
pY,_ = 0. To affect the appropriate change in
flows, the flows have to be taxed. This will in-
crease the value of the inflows and decrease the
value of the outflows. If taxes are required to be
proportional to real values, budgets cannot be
balanced, and if budgets are required to be bal-
anced, the resulting taxes can bear no general
relation to the real values. For each case
specifically, the appropriate taxes have to be de-
termined by modeling the interactions between
the economy and its environment.
Our last conclusion is in reference to possible
applications of the present study in the context of
the general equilibrium approach. The possibility
of deriving valuation multipliers for any open
system is important not only for deriving nonan-
thropocentric ecoindicators and summary mea-
sures of the health of ecosystems. It also allows
the derivation of an integrated set of intensive
variables for a system composed of economic and
Assuming the real values are specified in terms of a mone-
tary unit of account, the condition - m = u* Y,, < 0 means
that the unit of account has to leak out of the system as
long as the U*S and the ps, the real values and the taxes, are
proportional. Thus, if M monetary units are distributed ini-
tially among economic agents, (I/+)m = PM > 0 will be the
rate at which they are taken out of circulation. If budgets are
required to be balanced. no leakage is possible, and the
proportionality rule cannot hold.
S. Amir / Ecological Economics 10 (1994) 125-142 141
ecological agents. In this way, a single accounting
framework is founded, and this framework could
be used to determine the value to man of particu-
lar natural resources and environmental wealth in
general. Furthermore, the possibility of comput-
ing the state variables of the composed system is
invaluable for the study and prediction of future
ecological impacts of alternative economic poli-
cies. One, however, has to bear in mind that the
observed states, and hence the simulated ones,
are possibly guided by a nonconserved function
that requires transactions across the bound-
aries to remain unbalanced.
Acknowledgement
I would like to thank Paul Samuelson, Julian
Simon, Matthias Ruth, Jean Koch, Robert
Herendeen, Allen Kneese, David Simpson, Ray-
mond Kopp, Martin David, Jeffrey Hyman, Mario
Giampietro, Robert Costanza, the editor of this
journal, and several anonymous referees for their
valuable comments on earlier versions of this
paper. 1 have especially benefitted from fruitful
discussions with Bruce Hannon during years of
our collaboration, and from the editorial assis-
tance of Melissa Edeburn. Although I am grate-
ful to them all, the views expressed here and,
certainly, any remaining errors or misconceptions
are my sole responsibility.
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