market failure Archives - Page 14 of 14 - An Economic View of the Environment

Using Markets to Make Fisheries Sustainable

Around the world, over-fishing is leading to severe depletion of valuable fisheries. This is as true in U.S. coastal waters as it is in many other parts of the world. In New England waters, for example, after two decades of ever more intensive fishing, the groundfish fishery has essentially collapsed. But, we are not alone. According to the United Nations Environment Program, fully 25 percent of fisheries worldwide are in jeopardy of collapse due to over-fishing. Clearly, something needs to be done. Yet, what has long been considered the obvious answer – restrictions on fishing – has been shown time and time again to be the wrong answer. The right answer is enlightened use of markets.

The fundamental cause of the depletion of fish stocks is well known to economists: virtually all ocean fisheries are “open-access,” that is, fishermen – small operations or large corporations – can fish all they want. These individuals and companies are no more greedy than the rest of us, but because no one holds title to fish stocks in the open ocean, everyone races to catch as much as possible. Each fisherman receives the full benefit of aggressive fishing (that is, a larger catch), but none pay the full cost (an imperiled fishery for everyone). One fisherman’s choices have an effect on other fishermen (of this generation and the next), but in an open-access fishery – unlike a privately-held copper mine, for example – these impacts are not taken into account. What is individually rational adds up to collective foolishness, as the shared resource is over-exploited. This is the “tragedy of the commons.” What to do?

Government intervention is, alas, required. Fishermen don’t welcome such regulation in their economic sphere any more than anyone else does. And they have a point. Conventional regulatory approaches have driven up costs, but not solved the problem. And we know why. If the government limits the season, fishermen put out more boats. If the government limits net size, fishermen use more labor or buy more costly sonar. Economists call this over-capitalization. Costs go up for fishermen (as resources are squandered), but pressure on fish stocks is not relieved.

The answer is to adopt in fisheries management the same type of innovative policy that has been used for decades in the realm of pollution control – tradeable permits, called “Individual Transferable Quotas” ( ITQs) in the fisheries realm. Sixteen countries – some with economies much more dependent than ours on fishing – have adopted such systems with great success. New Zealand regulates virtually its entire commercial fishery this way. It’s had the system in place since 1986, and it’s been a great success, putting a brake on over-fishing and restoring stocks to sustainable levels - while increasing fishermen’s profitability!

There are several ITQ systems already in operation in the United States, including for Alaska’s pacific halibut and Virginia’s striped-bass fisheries. More important, the time is ripe for broader adoption of this innovative approach, because a short-sighted ban imposed by the U.S. Congress on the establishment of new ITQ systems has expired.

The first step in establishing an ITQ system is to establish the “total allowable catch.” The next step – and a crucial one – is to allocate shares of that total limit to fishermen in individual quotas that are theirs and theirs alone (read: well-defined property rights). Setting the individual quotas will not be easy. The guiding principle should be simple pragmatism – using the allocations to build political support for the system. Making the quotas transferable eliminates the problem of overcapitalization and increases efficiency, because the least efficient fishing operations find it more profitable to sell their quotas than to exploit them through continued fishing. If you can’t catch your whole share, you can sell part of your quota to someone else, instead of buying a bigger boat.

In addition, these systems improve safety by reducing incentives for fishermen to go out (or stay out) when weather conditions are dangerous. And it was just such perverse incentives of conventional fisheries regulation that were blamed for the tragic loss of life when a fishing boat was lost in a storm off the New England coast just a few winters ago.

Further, because ITQ systems eliminate the motivation for government to limit the duration of the fishing season, supplies available to consumers improve in quality. Prior to the establishment of an ITQ system for Alaskan halibut, for example, the government had reduced the fishing season to just two days, but subsequent to the introduction of the system, the season length grew to more than 200 days.

A decade ago, environmental advocates – led by the Environmental Defense Fund – played a central role in the adoption of the sulfur dioxide allowance trading program that’s cut acid rain by half and saved electricity generators and rate-payers nearly $1 billion annually, compared with conventional approaches. The time has come for environmentalists to join forces with progressive voices in the fishing industry and in government to set up ITQ systems that can keep fishermen in business while moving fisheries onto sustainable paths.

A Tale of Two Taxes

Whether they are called “revenue enhancements” or “user charges,” fear of the political consequences of taxes restricts debate on energy and environmental policy options in Washington. In a March 7^th post on “Green Jobs,” in which I argued that it is not always best to try to address two challenges with a single policy instrument, I also noted that in some cases such dual-purpose policy instruments can be a good idea, and I gave gasoline taxes as an example.

Although a serious recession is clearly not the time to expect political receptivity to such a proposal, the time will come — we all hope very soon — when the economy turns around, employment rises, and a sustained period of economic growth ensues. When that happens, serious consideration should be given to increases in the Federal tax on gasoline.

A gas tax increase — coupled with an offsetting reduction in other taxes, such as the Social Security tax on wages — could make most American households better off, while reducing oil imports, local pollution, urban congestion, road accidents, and global climate change. This revenue-neutral tax reform would exemplify the market-based approaches to environmental protection and resource management I examined in previous posts.

Such a change need not constitute a new tax, but a reform of existing ones. It is well known – both from economic theory and numerous empirical studies – that taxes tend to reduce the extent to which people undertake the taxed activity. In the United States, most tax revenues are raised by levies on labor and investment; the resulting reduction in these fundamentally desirable activities is viewed as an unfortunate but unavoidable side-effect of the need to raise revenue for government operations. Would it not make more sense to raise the revenue we need by taxing undesirable activities, instead of desirable ones?

Combustion of gasoline in motor vehicles produces local air pollution as well as carbon dioxide that contributes to global climate change, increases imports of oil, and exacerbates urban highway congestion. Can anyone really claim that — given a choice between discouraging work and discouraging gasoline consumption — it is better to discourage work?

According to the U.S. Department of Energy, a 50 cent gas tax increase could eventually reduce gasoline consumption by 10 to 15%, reduce oil imports by perhaps 500 thousand barrels per day, and generate about $40 billion per year in revenue.

Furthermore, this approach would be far more effective than on-going proposals to increase the Corporate Average Fuel Economy (CAFE) standards, which affect only new vehicles and lead to serious safety problems by encouraging auto makers to produce lighter vehicles. Also, remember that a major effect of CAFE standards has been to accelerate the shift from cars to SUVs and light trucks (so that overall fuel efficiency of new vehicles sold is no better than it was a decade ago, despite the great strides that have taken place in fuel efficiency technologies). As my Harvard colleague Martin Feldstein pointed out in The Wall Street Journal in 2006, the conventional approach “does nothing to encourage individuals to drive less, to use their cars more efficiently, or to shift sooner to new and more fuel efficient [and cleaner] vehicles.” A more enlightened approach — a market-based approach — would reward consumers who economize on gasoline use. And that is what a revenue-neutral gas tax is all about.

The revenue from the gas tax could be transferred to the Social Security Trust Fund and credited to current workers. If $40 billion per year from new gas tax revenues were transferred to Social Security, the payroll tax — the employee contribution to Social Security — could be cut by perhaps a third: a worker with annual wages of $30,000 would take home an additional $750 per year! The extra income would more than offset the cost of the gas tax, unless the worker drove over 35,000 miles per year in a car getting 25 miles or less per gallon. Rebating the gas tax in this way addresses the greatest concern about higher gas taxes — that they can hit hardest those workers who drive to their jobs. Further, a tax of this magnitude could be phased in gradually, perhaps no more than 10 cents per year over 5 years, allowing individuals and firms to adjust their consuming and producing behavior.

Proposals for gasoline tax increases in recent sessions of Congress would have dedicated the revenue to public spending (for transportation and other programs). A key difference is that the proposal I have outlined here is for a revenue-neutral change in which the gas tax revenue would be returned to Americans through reduced payroll taxes. To adopt some of the language I developed in my previous posts, such a change can be both efficient and equitable, and — for those reasons — perhaps even politically feasible.

Of course, such a scheme is not a panacea for U.S. energy and environmental problems. But it would make a significant contribution if enacted. On the other hand, political fear of the T-word in Washington may mean that it is never discussed seriously in public, let alone adopted. Most fear of taxes is due to politicians’ anxieties about asking their constituents to pay more. But an increase in the Federal gas tax, rebated through reduced payroll taxes would not cost most Americans any more and would have significant long-term benefits for the country. Still, fear of the T-word looms large; maybe it should be called an “All-American Ecologically Sound, Fully Recyclable, Anti-Terror, Energy-Independence Assessment.”

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.