A wonderful short piece from Scientific American on the pseudo-scientific roots of neoclassical economics (Someone alert Andrew Coyne!):
The 19th-century creators of neoclassical economics—the theory that now serves as the basis for coordinating activities in the global market system—are credited with transforming their field into a scientific discipline. But what is not widely known is that these now legendary economists—William Stanley Jevons, Léon Walras, Maria Edgeworth and Vilfredo Pareto—developed their theories by adapting equations from 19th-century physics that eventually became obsolete. Unfortunately, it is clear that neoclassical economics has also become outdated. The theory is based on unscientific assumptions that are hindering the implementation of viable economic solutions for global warming and other menacing environmental problems.
The physical theory that the creators of neoclassical economics used as a template was conceived in response to the inability of Newtonian physics to account for the phenomena of heat, light and electricity. In 1847 German physicist Hermann von Helmholtz formulated the conservation of energy principle and postulated the existence of a field of conserved energy that fills all space and unifies these phenomena. Later in the century James Maxwell, Ludwig Boltzmann and other physicists devised better explanations for electromagnetism and thermodynamics, but in the meantime, the economists had borrowed and altered Helmholtz’s equations.
The strategy the economists used was as simple as it was absurd—they substituted economic variables for physical ones. Utility (a measure of economic well-being) took the place of energy; the sum of utility and expenditure replaced potential and kinetic energy. A number of well-known mathematicians and physicists told the economists that there was absolutely no basis for making these substitutions. But the economists ignored such criticisms and proceeded to claim that they had transformed their field of study into a rigorously mathematical scientific discipline.
Keep reading for the whole list of nasty theoretical side-effects, but the most important one is that:
The costs of damage to the external natural environment by economic activities must be treated as costs that lie outside the closed market system or as costs that cannot be included in the pricing mechanisms that operate within the system.
As a result:
[Neo-Classical economics] constitutes one of the greatest barriers to combating climate change and other threats to the planet. It is imperative that economists devise new theories that will take all the realities of our global system into account.
I rather think, however, that author Robert Nadeau has missed some of the most interesting recent work in the economics of climate change. I and other's have written about the developing consensus among economists that seems to have followed on the heels of the climatological consensus. Richard Tol, for example, has come around and now supports a carbon tax. And if any single paper by any single researcher can be said to have triggered this emerging consensus, it is On Modeling and Interpreting the Economics of Catastrophic Climate Change by Harvard economist Marty Weitzman.
I cannot confess to being able to follow Mr. Weitzman's math, and you probably can't either, because it strains the limits of the professionals. But the For Dummies version seems to be roughly as follows (here is another attempt at the FD version):
AGW may give rise to any number of "high-impact low probability" disasters (melting Greenland ice-sheets, for example) the results of which would be so catastrophic as to confound the economist's standard cost benefit analysis (you can't really predict how many points having to abandon a flooded New York City will knock of the GDP).
And while these events have a low probability, their destructive effects are so extreme as to justify immediate action against them as a form of insurance policy. (In particular, high enough to set the price of carbon at $50 per ton U.S.)