Monday, February 11, 2013

Why Don't We Value Resources Better?

by Duncan Gromko

There was a great article in the National Journal last week about the costs of climate change. Coral Davenport lays out a lot of estimates of what the impact of climate change will be on industry, business, and the general health of the economy. Putting the emphasis on dollar amounts is a great way to frame the debate because you can start to compare the cost of reducing carbon emissions to the cost of inaction. Solar may be more expensive than coal (although the cost difference is shrinking quickly), but using coal and other fossil fuels has other costs, the most alarming among them: climate change.

An example of the costs is the increase in insurance pay outs due to disasters. 2011 and 2012 were the most costly years, with annual losses of around $60 billion (compared to an average of $27 billion). However, that pales in comparison to estimates for 2025: $270 billion.

If there are such high costs to climate change, why aren't they accounted for in the market?

Adam Smith's idea of the "invisible hand" suggests that free markets are the most efficient way to allocate resources and maximize well-being. When an Arsenal fan like me buys one more Arsenal jersey, the price I pay represents how much I value the the jersey: the marginal social benefit (MSB). The price of the labor and materials it took to produce the jersey is the marginal social cost (MSC). So my Arsenal jersey is perfectly in equilibrium: its production costs society the same amount that society benefits.

In this idealized world, the prices set by markets reflect the social benefit (MSB) and social cost (MSC) of good consumption. 

But things are rarely this perfect...if we could all just be Arsenal fans. Now, take a Chelsea jersey factory that dumps its effluent into a nearby river (any surprise that a team with a racist captain who taunts Americans post-911 would also produce their jerseys in a terrible way?). The polluted river is now less productive for fishermen or is creating public health problems. The cost of pollution is borne by people who have nothing to do with the buying and selling of Chelsea jerseys - the costs are "externalized." The value, or benefit, of the jerseys produced is high, but it doesn't take into account the impact, or cost, of the effluent. A solution is to charge the Chelsea factory a fee for those costs. This would drive up the price, decrease demand, and probably lead to fewer jerseys being created (or maybe the factory would find a way to reduce its impact).

So this is how a market failure, like the Chelsea jersey factory, undermines the "invisible hand" utopia. The price of a good is supposed to take into account its cost. But if part of the cost is externalized, the price signal is wrong.

Source: Mr. Wood

This can put us in a situation where marginal private cost is lower than marginal social cost and we end up consuming and producing more than we "should."

Greenhouse gas emissions are the ultimate externality. The cost of emitting carbon isn't borne by those who use a local river, but by the entire world.

This is economists' take on why we value resources poorly. What was frustrating to me in my economics study is how externalities and other market failures are kind of an afterthought at the end of the textbook: externalities are acknowledged, but they're not big enough to undermine the model. But, if we're talking about global ecosystem services being worth $33 trillion per year, then clearly the market is missing an important signal. It's not just greenhouse gas emissions and their effect on climate that is "externalized;" there are a host of environmental services that are not priced by the market. If the market model is going to be a useful tool for making economic decisions, there has to be a lot more research like Coral's and the political will to incorporate these environmental services into the cost of goods. Otherwise the invisible hand is going to lead to some very bad outcomes. This sort of analysis is why a carbon tax appeals to many people as a solution to climate change. If you can value the social cost of carbon and add its price to carbon goods, you'd get closer to the market utopia.

Another aspect is that these costs are distributed unevenly throughout society. People who were hurt by Hurricane Sandy or farmers who saw their production plummet in the summer drought are affected by climate change much more than me. What I like best about Coral's article was how she brought a personal element to these costs:

"And Strickland [a businessman] fully expects someone, whether it’s him or taxpayers, to pay more in the future, as sea levels climb higher. 'In the last couple of years, we’ve seen more and more evidence of the waters rising,” the accountant says. “I’m just a small businessman. I’m looking at my building, on the impact of this on me and my employees; but other people are going to start thinking, am I going to want to relocate my business here?'"

(DISCLAIMER: I'm sure Arsenal and Chelsea jerseys are actually produced in the same factory and have the same environmental cost. But it's still fun watching their captain fall flat on his face).

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