Archive for the 'Environment' Category

Mar 04 2013

Monopoly prices – to regulate or not to regulate, that is the question!

Competitively Priced Electricity Costs More, Studies Show – New York Times

The problem with monopolies, as our AP students have learned, is that a monopolistic firm, left to its own accord, will most likely choose to produce at an output level that is much lower and provide their product at a price that is much higher than would result from a purely competitive industry.Regulated Monopoly A monopolist will produce where its price is greater than its marginal cost, indicating an under-allocation of resources towards the product. By restricting output and raising its price, the monopolist is assured maximum profits, but at the cost to society of less overall consumer surplus or welfare.

Unfortunately, in some industries, because of the wide range of output over which economies of scale are experienced, it sometimes makes the most sense for only one firm to participate. Such markets are called “natural monopolies” and some examples are cable television, utilities, natural gas, and other industries that have large economies of scale. (click graph to see full-sized)

Government regulators face a dilemma in dealing with natural monopolistic industries such as the electricity industry. A electricity company with a monopoly in a particular market will base its price and output decision on the profit maximization rule that all unregulated firms will; they’ll produce at the level where their marginal revenue is equal to their marginal cost. The problem is, for a monopolist its marginal revenue is less than the price it has to charge, which means that at the profit maximizing level of output (where MR=MC), marginal cost will be less than price: evidence of allocative inefficiency (i.e. not enough electricity will be produced and the price will be too high for some consumers to afford).

Here arises the need for government regulation. A government concerned with getting the right amount of electricity to the right number of people (allocative efficiency) may choose to set a price ceiling for electricity at the level where the price equals the firm’s marginal cost. This, however, will likely be below the firm’s average total cost (remember, ATC declines over a WIDE RANGE of output), a scenario which would result in losses for the firm, and may lead it to shut down altogether. So what most governments have done in the past is set a price ceiling where the price is equal to the firm’s average total cost, meaning the firm will “break even”, earning only a “normal profit”; essentially just enough to keep the firm in business; this is known as the “fair-return price”.

Below AP Economics teacher Jacob Clifford illustrates and explains this regulatory dilemma. Watch the video and see how he shows the effect of the two price control options on the firm’s output and the price in the market.

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The article above examines the differences in the price of electricity in states which regulate their electricity prices and states that have adopted “market” or unregulated pricing, in which firms are free to produce at the MR=MC level:

“The difference in prices charged to industrial companies in market states compared with those in regulated ones nearly tripled from 1999 to last July, according to the analysis of Energy Department data by Marilyn Showalter, who runs Power in the Public Interest, a group that favors traditional rate regulation.

The price spread grew from 1.09 cents per kilowatt-hour to 3.09 cents, her analysis showed. It also showed that in 2006 alone industrial customers paid $7.2 billion more for electricity in market states than if they had paid the average prices in regulated states.”

The idea of deregulation of electricity markets was that removing price ceilings would lead to greater economic profits for the firms, which would subsequently attract new firms into the market. More competitive markets should then drive prices down towards the socially-optimal price, benefiting consumers and producers by forcing them to be more productively efficient in order to compete (remember “Economic Darwinism”?). It appears, however, that higher prices have not, as hoped, led to lower prices:

“Since 1999, prices for industrial customers in deregulated states have risen from 18 percent above the national average to 37 percent above,” said Mrs. Showalter, an energy lawyer and former Washington State utility regulator.

In regulated states, prices fell from 7 percent below the national average to 12 percent below, she calculated…

In market states, electricity customers of all kinds, from homeowners to electricity-hungry aluminum plants, pay $48 billion more each year for power than they would have paid in states with the traditional system of government boards setting electric rates…”

That $48 billion represents higher costs of production for other firms that require large inputs of energy in their own production, higher electricity bills for cash-strapped households, and greater profits and shareholder dividends for the powerful firms that provide the power. On the bright side, higher prices for electricity should lead to more careful and conservative use of power, reducing Americans’ impact on global warming (since the vast majority of the country’s power is generated using fossil fuels).

Here arises another question? Should we be opposed to higher profits for powerful electricity firms if their profits result in much needed energy conservation and a reduction in greenhouse gas emissions? An environmental economist might argue that if customers are to pay higher prices for their energy, it might as well be in the form of a carbon tax, which rather than increasing profits for a monopolistic firm would generate revenue for the government. In theory tax revenue could be used to subsidize or otherwise promote the development and use of “green energies”.

Whether customers paying higher prices for traditionally under-priced electricity is a good or bad thing depends on your views of conservation. But whether higher profits for a powerful electricity company are more desirable than increased tax revenue for the government are beneficial for society or not seems clear. If we’re paying higher prices, the resulting revenue is more likely to be put towards socially desirable uses if it’s in the government’s hands rather than in the pockets of shareholders of fossil fuel burning electricity monopolies.

Discussion Questions:

  1. Why do governments regulate the prices in industries such as natural gas and electricity?
  2. Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?
  3. Why, in reality, did the price of electricity in unregulated electricity markets ultimately increase so much that consumers in the market states paid billions of dollars more than in regulated states?
  4. What industries besides that for electricity share characteristics that might qualify them as “natural monopolies”? Which of the industries you identified should be regulated by government, and WHY?

227 responses so far

Nov 09 2012

Economic arguments for and against a carbon tax

Reuters – Long-shot carbon tax suddenly part of fiscal cliff debate

The article above suggests that during Barack Obama’s second term as president of the United States, the country may begin to seriously consider imposing a tax on carbon dioxide emissions. The justification for such a tax, points out the article, is two-fold:

The aftermath of Superstorm Sandy, which devastated parts of the U.S. East Coast last week, has raised fresh questions about the links between climate change and extreme weather events, which also makes the idea of a carbon tax more appealing.

A carbon tax is a mechanism to charge emitters of greenhouse gases, such as power plants and oil refiners, for each ton of carbon dioxide they emit.

Prospects for such a tax as a way to address pollution and climate are probably dim in a still deeply-divided Congress, but some analysts say the measure would be more attractive if positioned as a source of new revenue.

In fact, a recent report by the Congressional Research Service, suggesting a $20 per ton tax on carbon emissions could halve the U.S. budget deficit over time.

Such a tax would generate about $88 billion in 2012, rising to $144 billion by 2020, the report said, slashing U.S. debt by between 12 and 50 percent within a decade, depending on how high the deficit climbs, the report said.

America’s government budget has been in deficit every year since 2000, meaning the government spends more than it collects in taxes. Fears over the growing national debt and the impact it will have on future economic growth potential have led many in the US government to look for new ways to earn tax revenue for the government, even some ways that have bene considered taboo until now.

In my year 1 IB Economics course this week we have been learning about and evaluating taxes and subsidies in the markets for various goods. Generally, we learn that government intervention in free markets worsens the overall allocation of resources in the market economy, imposes more costs on society than benefits, and therefore leads to a loss of total welfare. For example, a tax on American beef in Switzerland helps keep the price of imported meat high, benefiting Swiss farmers, but overall the higher price of meet and the reduced quantity and variety available to consumers harms many in society to the benefit of the few cattle farmers. Such a tax, it can be argued, creates a loss of total welfare in society, as the tax’s cost outweighs its benefit.

But not ALL indirect taxes (those placed on the production and consumption of particular goods) reduce total welfare in society. A tax on a good that is over-consumed by the free market may actually improve total welfare as the higher cost to producers leads to a reduced supply, higher price, and a reduction in the quantity demanded in the market. A cigarette tax is the classic example. Without taxes on cigarettes, more people would smoke, creating more harmful effects for society, such as the ills of second-hand smoke, higher rates of lung cancer, greater demand for health care and the higher prices that this increased demand create for all of society, even non-smokers. Cigarette taxes are so widely employed by government and accepted by society that there is no debate whatsoever about their use.

But taxes on other goods that create ills for society are highly controversial, and for good reason. Perhaps one of the most debated and divisive tax proposals of recent years has been on the emission of carbon dioxide, a greenhouse gas emitted during the burning of fossil fuels. The main emitters of CO2 in the United States are the country’s electricity generating firms, which burn coal, gas and oil more than any other industry in the country. CO2 emissions are measured in tons, and a CO2 tax would apply to each ton of the gas emitted by fossil fuel consuming firms.

Arguments against a carbon tax

The primary argument against a tax on CO2 emissions is that it would drive up the costs of energy production, leading to higher energy costs for the nation’s households and firms. This boost in prices would increase costs to producers of all other goods and services in the economy, effectively reducing the supply in several key sectors of the US economy, leading to falling national output, more inflation and greater unemployment. American industry would become less competitive with other nation’s producers, leading to more factories closing down and moving overseas, taking American jobs with them.

Such a conclusion requires that a CO2 tax would, in fact, lead to significant decreases in the amount of energy demanded by the nation’s households and firms. In other words, it assumes a relatively elastic demand for electricity. It also assumes that as the price of fossil fuel generated electricity rises, there will be few alternative forms of electricity for firms to switch to. This leads us to the arguments for a carbon tax.

Arguments for a carbon tax

Energy is an essential good that consumers (whether they be households or firms) demand in large quantities regardless of the price. A carbon tax, which increases the cost and decreases the supply of fossil fuel energy, will not significantly reduce the amount of fossil fuel energy consumed in the United States; at least not in the short run, during which there will be very few substitutes for fossil fuel energy available to consumers.

However, one outcome that proponents of the tax hope for is an increase in the demand for alternative energies, such as wind and solar, which do not require the burning of fossil fuels. Such alternatives are not currently price-competitive with fossil fuels, but a carbon tax would make them more competitive, increasing demand for alternative energies and leading to a greater percentage of America’s total energy production coming from wind and solar.

The graphs below show the desired outcome of a CO2 tax on the markets for fossil fuel energy and renewable energies.

Notice that the tax does not lead to a significant decrease in the quantity of fossil fuel energy consumed in the short run. Businesses in the US will face higher costs, but energy costs are a relatively small proportion of most US industries’ total costs. (The biggest cost faced by US firms, not surprisingly, is labor costs). But the highly inelastic demand assures that fossil fuel energy prices will rise, leading to greater interest from consumers in alternative energies. In the graph on the right, we see an increase in the demand for renewables, leading to a greater quantity being produced.

But what might the long-run impact of a carbon tax be on the US energy sector? As we can see in the graph on the right above, greater demand for renewables will drive their prices up, which over time will increase the appeal of renewable energies to the country’s electricity producing giants. Slowly, the number of renewable energy producers will grow, as old coal or gas burning electricity plants are decommissioned and new wind or solar plants are installed. The supply of renewable energies should rise while the supply of fossil fuel energy should decrease. The result is an ever growing percentage of America’s total energy production generated using wind, solar, or other renewable sources of power. The graphs below show the possible long run impact of a carbon tax in the fossil fuel and renewable energy sectors.

Here we can see that in the long-run, the prices of renewable energies and fossil fuel energies will become closer as the supply of energy produced using wind and solar grows, making it more price-competitive and therefore reducing the demand for fossil fuel energies.Presumably, if the outcomes described above come to pass, the proposed carbon tax could lead to meaningful reductions in America’s greenhouse gas emissions over the long run, as the composition of the nation’s energy production slowly transitions away from non-renewable fossil fuels to renewable, non-polluting energy sources.

But what about the other reason the government is considering a carbon tax now? Remember those fears over the national debt and deficit? How effective would a carbon tax be at raising revenue to help the government balance its budget? To determine this, we must look again at the first graph we drew, only examine the impact of the tax on government, not just the market for fossil fuel energy.

In the graph above, we see that the tax creates a large chunk of tax revenue for the government, “about $88 billion in 2012, rising to $144 billion by 2020″. These figures seem optimistic, especially if the previous outcome in which the demand for fossil fuel energies falls in the long run comes to pass. But for now, at least from this Economics teacher’s perspective, a tax on carbon is a good first step towards both reducing American’s dependence on fossil fuels and generating desperately needed government revenues.

No responses yet

Nov 01 2012

“Cap & Trade” – An introduction market-based approaches to pollution reduction

Inside Obama’s Green Budget – Forbes.com

Some say that Global Warming may be the greatest market failure of all. This podcast was originally broadcast in January of 2007 while George Bush was still in office. The commentator claims that global warming is “nothing but one giant market failure”, arguing that the United States therefore must get serious about tackling the problem.

The allocation of resources towards carbon emitting industries has almost undoubtedly contributed to the warming of the planet over the last half century. Only recently have governments begun taking active measures to reduce the impact of industry on the environment through greater regulation of polluting industries, employing corrective taxes in some instances and market-based approaches to pollution reduction in others.

US President Barack Obama, unlike his predecessor, appears to be serious about correcting the “market failure” represented by global warming:

Obama’s budget, announced Thursday, looks to fund a host of new energy programs, from carbon sequestration to electric transmission upgrades. It would also provide the EPA with a $10.5 billion budget for 2010, a 34% increase over the likely 2009 budget. Nineteen million dollars of that would be used to upgrade greenhouse gas reporting measures.

The Interior Department would get $12 billion for 2010. The agency would use part of the money to asses the availability of alternative energy resources throughout the country.

Funding comes from elaborate carbon “cap and trade” program, which puts a price on emitting pollution and is the core of Obama’s plans. Starting in 2012, the government would sell permits giving businesses the right to emit pollution, generating $646 billion in revenue through 2019.

During those years, the number of available permits would gradually decline, forcing businesses to buy the increasingly scarce, and costly, rights to pollute on an open market. Obama hopes that the rising cost of permits will encourage businesses to invest in clean technologies as a cheaper alternative to meeting pollution mandates, helping to cut greenhouse gas production to 14% below 2005 levels by 2020.

Below is a diagram that illustrates precisely how the Obama cap and trade plan is meant to work. Notice that between 2012 and 2020 the cost to firms of emitting pollution will increase dramatically, while at the same time the total amount of carbon emissions in the US economy will fall due to regular reductions in the number of permits issued to industry.

market-for-pollution-rights_1

The Obama cap and trade scheme is not the first experiment with such a market based approach to externality reduction:

Europe established such a market in 2005. But some E.U. governments allocated too many credits at the outset, causing the value of some permits to fall by half and making it relatively easy for large polluters to simply buy credits rather than cut emissions. Overall emissions grew in 2005 and 2006. In 2008, E.U. emissions dropped 3%; 40% of that drop was attributed to the carbon trading scheme.

Europe’s cap and trade program took a few years before it began having any noticeable impact on the emission of carbon by European industry. While unpopular among the firms who are forced to pay to pollute, the fall in emissions in Europe shows that a market for carbon may be effective in forcing firms “internalize” the costs of carbon emissions, which until now have been born by society and the environment in the form of the negative effects of global warming.

Discussion Questions:

  1. Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?
  2. Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?
  3. Is making firms pay to pollute a good idea in the middle of a recession? Do you think that we should even be worrying about the environment when millions of people are losing their jobs and entire industries are struggling to survive?

58 responses so far

Jan 16 2012

Common access resource case study – Indonesia’s Reef Fish

This week we’ve been exploring the issues of common access resources and how they give rise to a market failure. The video below illustrates the tragedy of the commons in Indonesia’s fish populations.

The high demand for fresh seafood from Southern China and Hong Kong create demand for Indonesia’s reef fish species. Over the last decade, the fish stocks around the more populated Western islands of the archipelago have all but disappeared, so today fishermen have brought their unsustainable methods to the Eastern islands of Indonesia, using dynamite and cyanide to stun fish, which are then caught live and rapidly transported to the markets in China for consumption. According to some estimates, Indonesia’s fish stocks are declining by 30% per year, a rate at which they will be depleted within the next decade.

This poses several problems for both the consumers and producers of fresh fish. For the Chinese consumers, the increasing scarcity of fish in the next decade will mean rising prices and, eventually, the death of the market altogether. For Indonesian fishermen, the outcome is more dire; a loss of their livelihood as the fish stocks dry up.

This raises the question: Why do fisherman continue to use these unsustainable methods? Of course, in a competitive market with thousands of fisherman, if one individual chooses to fish using sustainable methods (using hook and line, for example), he risks catching fewer fish than the competition using cyanide and dynamite. Fewer fish mean less income and a lower standard of living. The rational thing for each individual fisherman, therefore, is to catch fish using the most productive method available. The tragedy of this is that the highest yielding methods are unsustainable, as the story explains, and before long the fish will be exploited to extinction.

The organization profiled in the video is using education to encourage fisherman to use sustainable methods to catch fish. Unfortunately, I fear this will not be enough to save the wild fish stock of Indonesia. The Indonesian government must intervene in the market to enforce strict catch limits, perhaps employing a permit scheme that would allow fishermen to buy and sell permits to catch a strictly controlled quantity of fish during a fishing season.

As it stands, however, Indonesia’s dwindling fish stocks demonstrate yet another example of the tragedy of the commons. Without clear property rights or management by a government, the common resource of Indonesia’s reef fish will continue to be exploited unsustainably,  leaving future fishing communities with fewer sources of income and future consumers with less variety of fish to consume and enjoy. The resource is over-exploited today, to the gain of today’s consumers and fisherman, at the expense of future generations.

3 responses so far

Jan 11 2012

The Tragedy of the Commons as a Market Failure

Over the last few weeks in our IB Economics class, we have been studying cases in which markets fail to achieve an efficient, socially optimal level of production and consumption when the private buyers and sellers are left to interact in a free market. Markets fail in many ways; sometimes they produce too much of a good, and sometimes too little is produced. There are some things society would benefit from having more of, while other things society would be better off with less than what is produced by the free market.

When the free market fails to achieve a socially optimal level of output, at which the costs and benefits not just of the individual consumers and producers are accounted for, but all social, environmental and health costs and benefits are weighed as well, the government may be able to improve on the free market outcome by intervening in some way. For example, certain goods deemed beneficial for society are simply under-provided by private firms: Education, infrastructure, public transportation, security, health care… these are all markets in which government often intervenes to increase the provision of the good to society. In other cases, government intervenes to decrease the amount of a good consumed: Cigarettes, alcohol, reckless driving, polluting factories, violence on TV, child pornography, dangerous drugs… in each of these cases governments tend to use taxes, regulation or legislation to reduce the amount of the harmful good available on the market.

Besides the merit (beneficial) goods and the demerit (harmful) goods described above, markets may fail in other ways as well. One notable form of market failure arises due to a phenomenon first articulated by American ecologist Garrett Hardin, who warned of the Tragedy of the Commons. In his 1968 essay, Hardin explained that when there exist common resources, for which there is no private owner, the incentive among rational users of that resources is to exploit it to the fullest potential in order to maximize their own self gain before the resource is depleted. The tragedy of the commons, therefore, is that common resources will inevitably be depleted due to humans’ self-interested behavior, leaving us with shortages in key resources essential to human survival.

Each of the videos below illustrates a different example of the tragedy of the commons. Watch the videos and think about how each applies Hardin’s concept.

Example 1: Thousands of fishermen empty lake in minutes:

Example 2 – Dr. Suess’s The Lorax

Example 3 – Tuna fishing

In each of the videos above, there is a common resource (fish and trees) over which no ownership has previously been established. The resource users (the Malian fishermen, the Once-ler and his family and the tuna boat), all have a strong incentive to maximize their own short term gain by extracting and exploiting the resource as quickly as possible.

  • In the Mali fishing hole, the outcome is observable: within minutes the resource is depleted and there are no more fish for for future fisherman to enjoy.
  • In The Lorax the result of the Once-ler’s exploitation of the forest is foretold in the beginning of the story when the young boy comes upon the desolate outskirts of his town.
  • The tragedy of the commons acts as a warning to the tuna fishing industry, in which there are still tuna surviving in the world’s oceans, but at the rates industrial fishing boats such as the Albatun Tres exploit the resource, it will not be around much longer.
In each instance above, a market failure occurs. Due to the lack of private ownership over valuable resources, self-interested individuals stand to gain by exploiting them to the fullest extent possible while they still exist. The unfortunate outcome is that over time the resources are exploited unsustainably until they are ultimately depleted. As in the case of merit and demerit goods, the market failure of common resources provides an opportunity for government to intervene to achieve a more socially optimal allocation of resources. In the interview below, Garrett Hardin suggests that there are only two possible solutions to the tragedy of the commons. Watch the video and then respond to the discussion questions that follow.

Garret Hardin – the Tragedy of the Commons

Discussion Questions:

  1. Hardin refers to Karl Marx’s adage “from each according to his abilities, to each according to this needs.” What does Hardin have against this socialist idea?
  2. How does Hardin’s example of a “common pasture” illustrate the tragedy of the commons? How is a common pasture similar to the three examples in the videos above?
  3. According to Hardin, what are the only two solutions to the common pasture problem? Which of these solutions do you think would be most socially desirable?
  4. Explain Hardin’s claim that “the unmanaged commons cannot possibly work once the population gets above a certain size”. Of the world’s common resources today, what are some examples of common resources that remain unmanaged?
  5. Whose responsibility should it be to decide how common resources should be dealt with?
  6. Do you agree with Hardin’s claim that “the world cannot possibly live at the American standard of living at its present population size”? Which of his predictions do you think is most likely to occur: Will the American (and Western European) standard of living have to go down or will the number of people in the world have to be reduced? Or is there a third possibility? Discuss.

5 responses so far

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