Maladaptation to environmental degradation and the interplay between negative and positive externalities

Abstract

This paper investigates the possible dynamics that may emerge in an economy in which agents adapt to environmental degradation by increasing the produced output to repair the damages of environmental degradation. The analyzed economy is characterized by both positive and negative externalities. On the one hand, an increase in production-related environmental degradation lowers the net income left at disposal for consumption and investment; on the other hand, it induces an increase in labor and capital to repair environmental damages from production, which enhances the positive externalities occurring in the production process. From the analysis of the model we show that there can be two steady states but only the one with lower capital level can be locally attractive. Both local and global indeterminacy may arise in the model, even with decreasing returns to scale. It follows that one cannot predict a priori which path the economy will follow when converging to an equilibrium, nor the equilibrium the dynamics will eventually converge to. In particular, the trajectories emerging from the model may eventually lead the economy to be trapped in a Pareto-dominated equilibrium with lower capital and higher environmental degradation levels. Moreover, the interplay between positive and negative externalities generates a rich set of possible trajectories that may lead to opposite extreme outcomes, namely, either infinite growth or the collapse of the economy.