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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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.

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