Thursday, September 22, 2005

Second-Best Gas Policy

[Cross-posted on The Agitator.]

Via Don Boudreaux, I find James Surowiecki arguing on NPR for a 50-cent hike in the gasoline tax.

Surowiecki bases his argument on straightforward Pigovian externality theory. Using fossil fuels creates external costs in the form of air pollution and other environmental effects. Since these costs are not included in the price of fuel, drivers tend to drive too much and too often. A tax would internalize the pollution cost, giving drivers an incentive to cut back.

Boudreaux promised to address this issue later, and focused instead on a different flaw in Surowiecki’s analysis. But I’m going to beat him to the punch. The main problem here is that Surowiecki looks only at one potential source of market failure (external costs) while failing to consider another (imperfect competition). According to the economic theory of the second-best, it turns out that when there exist multiple market imperfections, they can actually offset each other – and fixing one can exacerbate the other. Oil and gas are perfect examples. The external cost from pollution means the market price of gas is too low. But the existence of a moderately effective cartel, OPEC, means the market price is too high. These effects at least partially offset each other. It could be, for instance, that the cartel-premium is large enough to effectively internalize the pollution externality. If so, then taxing gasoline would induce drivers to drive too little.

So which of the two effects predominates? I don’t know, and I’ll bet Surowiecki doesn’t either. I do know that 50-cent figure -- on top of the taxes we already pay -- sounds suspiciously like a number he pulled out of his butt.

(I will give Surowiecki credit for this correct point: that if we assume gasoline use should be reduced, taxes are a more efficient means of achieving that goal than mandating fuel economy standards.)

4 comments:

Glen Whitman said...

Ben:

"The environmental effect is totally unrelated market wise to the cartel." It's related in the sense that matters: both of them affect the price of gas. The environmental effect tends to make the price too low. The cartel effect tends to make it too high. Therefore, these effects at least partially offset each other.

"In the big picture, there is as much chance that this kind of coincidental inefficiency hurts the environment as there is chance it helps it." Untrue. To the extent the cartel drives up prices, there will be less pollution.

Your Wal-Mart story is one potential application of the theory of the second-best, but it's definitely not the only one. My example is another. Here's how they're related. In general, having fewer firms is undesirable because it tends to drive up prices. But having fewer firms can also be good, because larger firms can exploit economies of scale, which tends to drive *down* prices. Which of these effects is larger? Either could be (though in the case of the actual Wal-Mart, the latter effect is clearly the more important).

"But wouldn’t the price the cartel charge go down a little if this tax would be implemented?" No. The price would go up. It's true that some of the tax would be absorbed by the producers, so the price wouldn't go up by the entire amount of the tax. But the net effect would still be positive.

"Shouldn’t the money from the higher price go towards indemnifying those affected by the environmental problems?" That would be nice, but it's not always possible -- at least not without exacerbating other problems. And is there any reason to think the revenues from gas taxes go to environmental victims? The government had already spent all its tax dollars (on a whole slew of pork barrel projects) when Katrina hit, which is why it had to go into even greater debt to provide disaster relief.

Glen Whitman said...

Ben -- I think we're talking past each other, because you're talking about fairness or justice, while I'm talking about efficiency. Apparently, your position is that people have a property right to clean air and deserve to get paid for any infringement of it as a matter of justice. I, on the other hand, was talking about giving people incentives that will lead to the value-maximizing level of gasoline use (by which I mean consuming all and only those gallons of gasoline whose marginal benefits exceed their marginal costs to all parties).

I'm not saying your concern with fairness is wrong, but I do think it's tangential to the question at hand. Surowiecki made an economic externality argument, which is *not* generally understood as a claim about fairness, but as a claim about efficiency. The claim is that negative externalities lead to inefficiently high levels of consumption, not that they unfairly transfer wealth from one group to another. The distribution of wealth is an important but distinct question.

Even if we do focus on the fairness issue, you should ask whether a tax will really achieve it. Gas taxes are nominally earmarked for transportion purposes, but the reality is that governments use them as general-purpose slush funds. Even if the funds went only to transportion, that would arguably be a subsidy for the creators of the externality (drivers), not compensation of pollution victims (breathers of air in general, including pedestrians).

"The example you gave was just meant as an example of market failure which could offset the environmental effect in which case there is no a priori evidence that the sum of the market failures other than the environment externality go one way or the other."

That's right, and I admitted that in the original post. I said I didn't know which effects predominated. (It is clear, though, the externality effect and cartel effect point in opposite directions, so they at least partially offset each other.) Surowiecki seemed to think the existence of a negative externality was prima facie evidence that a gas tax -- and a higher one at that -- was justified on economic grounds. My point was that Surowiecki could not claim that degree of certainty, much less justify a number as specific as 50 cents.

Glen Whitman said...

This debate has probably outlived its usefulness, but I'll respond to a couple of points.

First, with respect to the costs of environmental damage, you've slightly shifted your argument. Earlier, you were talking about individuals as victims of pollution. Now you're talking about the government as a victim, inasmuch as current policies obligate the government to make certain expenditures related to environmental damage. The idea, then, is that the government needs to collect enough revenue to pay for these expenditures. That's a fine argument, but it *is* an argument about fairness, because the necessary revenue could be collected through any kind of tax. Your advocacy of a *gas* tax presumably rests on your sense that drivers ought to bear the burden. This is distinct from an *incentive-based* argument for a gas tax, which is what Surowiecki's externality argument is all about.

Second, it's true that efficiency arguments take everyone (not just American citizens) into account. But when I mentioned the benefits of gallons of gas, I wasn't primarily talking about benefits to OPEC -- I was talking about the value consumers place on driving. From that gross benefit, we need to subtract two kinds of cost: costs of production and external costs (like pollution). OPEC experiences the cost of production, and they receive a portion of the consumer benefits via the price of oil. So here's another way of putting my point: when OPEC successfully drives up prices, it gives drivers an incentive to drive less, which reduces the environmental cost of driving to the general (American) public. Thus, OPEC arguably does a service to American air-breathers at the very same time it does a disservice to American drivers.

Glen Whitman said...

Well, if you want to continue the discussion, I'm happy to do so.

"I think my arguments were always meant to be applied at the government level; otherwise I would have suggested something like giving individuals rights to sue oil companies to get remedy for damages from pollution instead of taxes..."

Taxes can serve a couple of different purposes. One of them is to raise revenue. The other is to change people's behavior in some way. When someone proposes a tax to solve an externality problem, they are generally talking about the latter goal. That is definitely what economists are talking about, and remember that (a) economists invented the term 'externality', and (b) Surowiecki is a financial columnist who assuredly has some economics training.

I admit that I'm reading a little into his statements, because he didn't talk for that long. But when someone invokes the term 'externality' and proposes a tax to solve it, they are bringing in a lot of economic theory as baggage.

"Your trying to separate incentive and fairness makes me feel weird. I never heard anything like it (albeit I am not an economist) and I don’t see how it would be a useful abstraction." Well, the distinction is quite common in economics. The institutional structures that give people good incentives often do not produce results that people consider fair, and institutional structures designed to produce fair results often yield inefficient incentives.

For example, welfare policies are often motivated by a sense of fairness, but they also can give poor people an incentive to work less, have excessive children, etc. That doesn't mean the welfare policies are necessarily bad, because you might consider fairness (or equity or equality or whatever) important enough to justify some inefficiency. But it is indeed possible to distinguish between fairness and efficiency, and to observe occasional conflicts between them.

"A pure _incentive based_ economy means it’s ok to steal as long as the thief pays the Right Price (TM) to _someone_." Well, no. It turns out that laws against theft can be justified on efficiency grounds. When people don't have secure property rights, it reduces their incentive to engage in productive behavior because they don't get to keep everything they earn. In addition, the possibility of successful theft encourages people to spend scarce resources just transferring wealth from one person to another, rather than engaging in activity that increases wealth overall. (I'm not saying this is the *only* justification for laws against theft, though. You could certainly make arguments based on fairness or justice as well.)

Your point about the difficulty of having gov't establish the "Right Price" for things is exactly why, on efficiency grounds, it's usually undesirable to allow involuntary transfers. When something is tranferred involuntarily, we have no assurance that the value of the item to the taker is greater than its value to whoever took it. Requiring consent and payment, though, mean both parties must find the trade advantageous and therefore the buyer's value must exceed the seller's.

I think some confusion can be cleared up by stating what the "right price" is from an efficiency perspective. In general, the right price is one that's exactly equal to the true marginal cost of the good, including both marginal production costs and marginal external costs. This price is desirable because it means consumers will consume all, *and only*, those units whose added value to the consumers is greater than the added cost to everyone involved.

Economists do not usually think government needs to set this "right price," because market forces will do it on their own. But market failure theories point out instances in which the right price allegedly won't emerge on the market.

The standard theory of negative externalities says they are bad because they cause price to fall *below* the true marginal cost, since buyers and sellers don't take the external component of the cost into account.

The standard theory of cartels (and other forms of imperfect competition) says they are bad because they allow firms to charge prices *above* the true marginal cost.

Both of these are efficiency problems. But note that if both occur, they must to some extent offset each other. The price could even, coincidentally, end up being the efficient one. (I'm not saying that's so here. The price could be too high or too low, depending on which effect is larger. My point was that we, and Surowiecki, don't know.)

"What do you mean by 'the value that consumers place on driving'? Gas is not a service provided for free! The value the consumer places on gas is paid for at the pump." Actually, no. For most consumers, the value is higher than the price they paid at the pump. People buy things when the value to them is greater than or equal to the price. The difference between the two is called the consumer surplus. Only the marginal customer -- the customer for whom the product is just barely worth buying -- has a valuation equal to the price at the pump.

"The cost of production and profit margin
+ the cost incurred by the cartel (to the US consumer this *is* a cost)
+ the pollution costs"

You're double-counting, because the cost incurred by the cartel *is* the profit margin. Now, from an efficiency perspective, the existence of a large profit margin means the price is too high (above marginal cost), and therefore consumers will consume too little. But if there are pollution costs that haven't been incorporated into the price, then the effect of the profit margin isn't so bad after all.