The Myths of Market Prices and Efficiency

In my two previous posts I described a pair of prevalent myths regarding how economists think about the environment: “the myth of the universal market” ­– the notion that economists believe that the market solves all problems; and “the myth of simple market solutions” — the notion that economists always recommend simple market solutions for social problems. In response to those two myths, I noted that in the environmental domain, perfectly functioning markets are the exception, not the rule; and that no particular form of government intervention is appropriate for all environmental problems.

A third myth is that when non-market solutions are considered, economists use only market prices to evaluate them. No matter what policy instrument is chosen, the environmental goal must be identified. Should vehicle emissions be reduced by 10, 20, or 50 percent? Economists frequently try to identify the most efficient degree of control — that which provides the greatest net benefits. This means that both benefits and costs need to be evaluated. True enough, economists typically favor using market prices whenever possible to carry out such evaluations, because these prices reveal how people actually value scarce amenities and resources. Economists are wary of asking people how much they value something, because respondents may not provide honest assessments of their own valuations. Instead, economists prefer to “watch what they do, not what they say,” as when individuals reveal their preferences by paying more for a house in a neighborhood with cleaner air, all else equal.

But economists are not concerned only with the financial value of things. Far from it. The financial flows that make up the gross national product represent only a fraction of all economic flows. The scope of economics encompasses the allocation and use of all scarce resources. For example, the economic value of the human-health damages of environmental pollution is greater than the sum of health-care costs and lost wages (or lost productivity), as it includes what lawyers call “pain and suffering.” Economists might use a market price indirectly to measure revealed rather than stated preferences, but the goal is to measure the total value of the loss that individuals incur.

For another example, the economic value of some parcel of the Amazon rain forest is not limited to its financial value as a repository of future pharmaceutical products or as a location for ecotourism. Such “use value” may only be a small part of the properly defined economic valuation. For decades, economists have recognized the importance of “non-use value” of environmental amenities such as wilderness areas or endangered species. The public nature of these goods makes it particularly difficult to quantify the values empirically, as we cannot use market prices. Benefit-cost analysis of environmental policies, almost by definition, cannot rely exclusively on market prices.

Economists try to convert all of these disparate values into monetary terms because a common unit of measure is needed in order to add them up. How else can we combine the benefits of ten extra miles of visibility plus some amount of reduced morbidity, and then compare these total benefits with the total cost of installing scrubbers to clean stack gases at coal-fired power plants? Money, after all, is simply a medium of exchange, a convenient way to compare disparate goods and services. The dollar in a benefit-cost analysis is nothing more than a yardstick for measurement and comparison.

A fourth and final myth is that economic analyses are concerned only with efficiency rather than distribution. Many economists do give more attention to aggregate social welfare than to the distribution of the benefits and costs of policies among members of society. The reason is that an improvement in economic efficiency can be determined by a simple and unambiguous criterion C an increase in total net benefits. What constitutes an improvement in distributional equity, on the other hand, is inevitably the subject of much dispute. Nevertheless, many economists do analyze distributional issues thoroughly. Although benefit-cost analyses often emphasize the overall relation between benefits and costs, many analyses also identify important distributional consequences. Indeed, within the realm of global climate change policy, much of the economic analysis is dedicated to assessing the distributional implications of alternative policy measures.

So where does this leave us? First, economists do not believe that the market solves all problems. Indeed, many economists make a living out of analyzing Amarket failures@ such as environmental pollution in which laissez faire policy leads not to social efficiency, but to inefficiency. Second, when economists identify market problems, their tendency is to consider the feasibility of market solutions because of their potential cost-effectiveness, but market-based approaches to environmental protection are no panacea. Third, when market or non-market solutions to environmental problems are assessed, economists do not limit their analysis to financial considerations, but use monetary equivalents in benefit-cost calculations in the absence of a more convenient unit. Fourth and finally, although the efficiency criterion is by definition aggregate in nature, economic analysis can reveal much about the distribution of the benefits and the costs of environmental policies.

Having identified and sought to dispel four prevalent myths about how economists think about the natural environment, I want to acknowledge that my profession bears some responsibility for the existence of such misunderstandings about economics. Like our colleagues in the other social and natural sciences, academic economists focus their greatest energies on communicating to their peers within their own discipline. Greater effort can certainly be given by economists to improving communication across disciplinary boundaries. And that is one of my key goals in this blog in the weeks and months ahead.

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The Myth of Simple Market Solutions

I introduced my previous post by noting that there are several prevalent myths regarding how economists think about the environment, and I addressed the “myth of the universal market” ­– the notion that economists believe that the market solves all problems.  In response, I noted that economists recognize that in the environmental domain, perfectly functioning markets are the exception, not the rule.  Governments can try to correct such market failures, for example by restricting pollutant emissions.  It is to these government interventions that I turn this time.

A second common myth is that economists always recommend simple market solutions for market problems.  Indeed, in a variety of contexts, economists tend to search for instruments of public policy that can fix one market by introducing another.  If pollution imposes large external costs, the government can establish a market for rights to emit a limited amount of that pollutant under a so-called cap-and-trade system.  Such a market for tradable allowances can be expected to work well if there are many buyers and sellers, all are well informed, and the other conditions I discussed in my last posting are met.

The government’s role is then to enforce the rights and responsibilities of permit ownership, so that each unit of emissions is matched by the ownership of one permit.  Equivalently, producers can be required to pay a tax on their emissions.  Either way, the result — in theory — will be cost-effective pollution abatement, that is, overall abatement achieved at minimum aggregate cost.

The cap-and-trade approach has much to recommend it, and can be just the right solution in some cases, but it is still a market.  Therefore the outcome will be efficient only if certain conditions are met.  Sometimes these conditions are met, and sometimes they are not.  Could the sale of permits be monopolized by a small number of buyers or sellers?  Do problems arise from inadequate information or significant transactions costs?  Will the government find it too costly to measure emissions?  If the answer to any of these questions is yes, then the permit market may work less than optimally.  The environmental goal may still be met, but at more than minimum cost.  In other words, cost effectiveness will not be achieved.

To reduce acid rain in the United States, the Clean Air Act Amendments of 1990 require electricity generators to hold a permit for each ton of sulfur dioxide (SO2) they emit.  A robust permit market exists, in which well-defined prices are broadly known to many potential buyers and sellers.  Through continuous emissions monitoring, the government tracks emissions from each plant.  Equally important, penalties are significantly greater than incremental abatement costs, and hence are sufficient to ensure compliance.  Overall, this market works very well; acid rain is being cut by 50 percent, and at a savings of about $1 billion per year in abatement costs, compared with a conventional approach.

A permit market achieves this cost effectiveness through trades because any company with high abatement costs can buy permits from another with low abatement costs, thus reducing the total cost of reducing pollution.  These trades also switch the source of the pollution from one company to another, which is not important when any emissions equally affect the whole trading area.  This “uniform mixing” assumption is certainly valid for global problems such as greenhouse gases or the effect of chlorofluorocarbons on the stratospheric ozone layer.  It may also work reasonably well for a regional problem such as acid rain, because acid deposition in downwind states of New England is about equally affected by sulfur dioxide emissions traded among upwind sources in Ohio, Indiana, and Illinois.  But it does not work perfectly, since acid rain in New England may increase if a plant there sells permits to a plant in the mid-west, for example.

At the other extreme, some environmental problems might not be addressed appropriately by a simple, unconstrained cap-and-trade system.  A hazardous air pollutant such as benzene that does not mix in the airshed can cause localized “hot spots.”  Because a company can buy permits and increase local emissions, permit trading does not ensure that each location will meet a specific standard.  Moreover, the damages caused by local concentrations may increase nonlinearly.  If so, then even a permit system that reduces total emissions might allow trades that move those emissions to a high-impact location and thus increase total damages.  An appropriately constrained permit trading system can address the hot-spot problem, for example by combining emissions trading with a parallel system of non-tradable ambient standards.

The bottom line is that no particular form of government intervention, no individual policy instrument – whether market-based or conventional – is appropriate for all environmental problems.  There is no simple policy panacea.  The simplest market instruments do not always provide the best solutions, and sometimes not even satisfactory ones.  If a cost-effective policy instrument is used to achieve an inefficient environmental target — one that does not make the world better off, that is, one which fails a benefit-cost test – then we have succeeded only in “designing a fast train to the wrong station.”  Nevertheless, market-based instruments are now part of the available environmental policy portfolio, and ultimately that is good news both for environmental protection and economic well-being.

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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.

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