Managing the environment and the economy in the presence of hysteresis and irreversibility

The shallow lake optimal management problem is one of the simplest ecological-economic interest conflict models for which several qualitatively different long run outcomes are possible. We extend the original model by adding the capital stock of an industry as a second state variable. A government can mitigate the effects of pollution arising from industrial activities by imposing the requirement to abate emissions. Within this framework two scenarios are examined. In the social optimal benchmark, the social planner optimally allocates investment. In the competitive equilibrium, market forces determine the investment in capital, but the social planner can still abate emissions. We show that in the case of irreversibilities catastrophes are avoided in the competitive equilibrium when it is socially optimal to do so. However, in the competitive equilibrium, either the catastrophe is avoided in an inefficient way or the catastrophe is badly managed. In case of hysteresis, catastrophes are almost always avoided. Moreover, the decision to avoid catastrophes does not depend on long-term considerations.