The Myth of the Universal Market

Communication among economists, other social scientists, natural scientists, and lawyers is far from perfect. When the topic is the environment, discourse across disciplines is both important and difficult. Economists themselves have likely contributed to some misunderstandings about how they think about the environment, perhaps through enthusiasm for market solutions, perhaps by neglecting to make explicit all of the necessary qualifications, and perhaps simply by the use of technical jargon.

So it shouldn’t come as a surprise that there are several prevalent and very striking myths about how economists think about the environment. Because of this, my colleague Don Fullerton, a professor of economics at the University of Illinois, and I posed the following question in an article in Nature:  how do economists really think about the environment? In this and several succeeding postings, I’m going to answer this question, by examining — in turn — several of the most prevalent myths.

One myth is that economists believe that the market solves all problems. Indeed, the “first theorem of welfare economics” states that private markets are perfectly efficient on their own, with no interference from government, so long as certain conditions are met. This theorem, easily proven, is exceptionally powerful, because it means that no one needs to tell producers of goods and services what to sell to which consumers. Instead, self-interested producers and self-interested consumers meet in the market place, engage in trade, and thereby achieve the greatest good for the greatest number, as if “guided by an invisible hand,” as Adam Smith wrote in 1776 in The Wealth of Nations. This notion of maximum general welfare is what economists mean by the “efficiency” of competitive markets.

Economists in business schools may be particularly fond of identifying markets where the necessary conditions are met, where many buyers and many sellers operate with very good information and very low transactions costs to trade well-defined commodities with enforced rights of ownership. These economists regularly produce studies demonstrating the efficiency of such markets (although even in this sphere, problems can obviously arise).

For other economists, especially those in public policy schools, the whole point of the first welfare theorem is very different. By clarifying the conditions under which markets are efficient, the theorem also identifies the conditions under which they are not. Private markets are perfectly efficient only if there are no public goods, no externalities, no monopoly buyers or sellers, no increasing returns to scale, no information problems, no transactions costs, no taxes, no common property, and no other distortions that come between the costs paid by buyers and the benefits received by sellers.

Those conditions are obviously very restrictive, and they are usually not all satisfied simultaneously. When a market thus “fails,” this same theorem offers us guidance on how to “round up the usual suspects.” For any particular market, the interesting questions are whether the number of sellers is sufficiently small to warrant antitrust action, whether the returns to scale are great enough to justify tolerating a single producer in a regulated market, or whether the benefits from the good are “public” in a way that might justify outright government provision of it. A public good, like the light from a light house, is one that can benefit additional users at no cost to society, or that benefits those who “free ride” without paying for it.

Environmental economists, of course, are interested in pollution and other externalities, where some consequences of producing or consuming a good or service are external to the market, that is, not considered by producers or consumers. With a negative externality, such as environmental pollution, the total social cost of production may thus exceed the value to consumers. If the market is left to itself, too many pollution-generating products get produced. There’s too much pollution, and not enough clean air, for example, to provide maximum general welfare. In this case, laissez-faire markets — because of the market failure, the externalities — are not efficient.

Similarly, natural resource economists are particularly interested in common property, or open-access resources, where anyone can extract or harvest the resource freely. In this case, no one recognizes the full cost of using the resource; extractors consider only their own direct and immediate costs, not the costs to others of increased scarcity (called “user cost” or “scarcity rent” by economists). The result, of course, is that the resource is depleted too quickly. These markets are also inefficient.

So, the market by itself demonstrably does not solve all problems. Indeed, in the environmental domain, perfectly functioning markets are the exception, rather than the rule. Governments can try to correct these market failures, for example by restricting pollutant emissions or limiting access to open-access resources. Such government interventions will not necessarily make the world better off; that is, not all public policies will pass an efficiency test. But if undertaken wisely, government interventions can improve welfare, that is, lead to greater efficiency. I will turn to such interventions in a subsequent posting..

Opportunity for a Defining Moment

The inauguration of Barack Obama as the forty-fourth President of the United States is a defining moment in American history. For most Americans and countless others around the world, this is an inspiring political transition. The question we must face, however, is whether compelling inspiration will lead to effective action. As I wrote in a Boston Globe op-ed (November 12, 2008) one week after election day, environment and energy issues — particularly climate change policy — provide a microcosm of the forces that are shaping and will shape the actions of the new Administration and Congress.

About eight years ago, President-Elect George W. Bush promised to be President for all the people, not just those who had voted him into office. Bush’s ability as Texas Governor to bridge differences across the political aisle provided cause for optimism.

But hope for a centrist and sensible Presidency dissolved under the influence of White House political operative Karl Rove and Vice President Dick Cheney. The Bush Administration moved not to the center, but toward solidifying its base on the political right. Nowhere was this more apparent than in energy and environmental policy, with Vice President Cheney running energy policy, and EPA Administrator Christie Whitman virtually driven from office.

Will the environment and energy team of President Obama respond effectively to the serious challenges that lie ahead? Or will we find that the corporate lobbyists who filled so many key environmental positions in the Bush Administration have simply been replaced by strident advocates from the other end of the political spectrum? In other words, will ideology trump reason?

The first sign of trouble will be if the Administration issues an “endangerment finding” for carbon dioxide, as promised by the Obama campaign, thereby pleasing and solidifying President Obama’s political base, but also playing into the hands of those who oppose climate policy action, tying up progress with litigation, driving up costs, and accomplishing little or nothing.

Ultimately, will the Obama White House work with Congress to develop climate strategies that are scientifically sound, economically sensible, and thereby politically pragmatic? Will the new President –with impressive Democratic majorities in both houses of Congress — take on the difficult task of crafting meaningful climate legislation?

The only politically feasible approach that can make a real dent in the problem is a comprehensive, upstream cap-and-trade system to reduce carbon dioxide emissions 50 to 80 percent below 1990 levels by 2050. The declining cap will increase the cost of polluting, thereby discouraging the use of the most carbon-intensive fossil fuels and providing powerful incentives for energy conservation and technology innovation.

The system could start with a 50-50 split of auctioned and free allowances, gradually moving to 100% auction over 25 years. To establish political support in the short term, free allowances should be targeted to sectors that are most burdened by the policy. And the auction revenue — which will increase over time — can be used to compensate low-income consumers, finance research and development, reduce the federal deficit, or cut taxes.

The best option may be to make the program revenue-neutral by returning all of the auction revenue to citizens through direct cash dividends or annual tax credits. This can go a long way towards making the legislation palatable to Republicans and Democrats alike who are reticent to take any actions that even resemble a tax increase.

By making the overall emissions cap gradually become more stringent over time, costs can be greatly reduced by avoiding premature retirement of existing capital stock, reducing vulnerability to siting bottlenecks, and ensuring that long-lived capital investments incorporate appropriate advanced technology.

Still, the costs of meaningful action will be significant, with impacts on gross domestic product eventually reaching up to 1 percent per year. But the longer the world waits to begin taking serious action, the more ambitious will emission reduction targets inevitably become, as atmospheric greenhouse gases continue to accumulate.

The bottom line is that getting serious about global climate change will not be cheap and it will not be easy. Beware of claims to the contrary. In the midst of a significant economic downturn, with businesses closing and unemployment on the rise, it makes sense for the new Administration to give its greatest attention to economic recovery. There is nothing wrong with sequencing policies. But if current predictions about the consequences of another few decades of inaction are correct, this defining moment provides an important opportunity for serious and sensible action..