Sunday, June 28, 2009

Confusion and Misinformation on Cap-and-Trade

Republicans in Congress have been reciting a set of talking points regarding the recent cap-and-trade legislation that are misleading. In this entry I'm going to explain a bit about how cap-and-trade works, and why "it will drive up energy prices" is a dumb complaint to make.

First a bit about pollution. The problem with pollution is that the person making it doesn't pay the full costs of it, so he or she does too much of it. That is, the owners of the power plant emitting carbon dioxide will not bear much of the costs of global warming, so they emit whatever amount they find convenient, unless forced to do otherwise. This is called a negative externality--the costs are external to the person creating them. Economists generally prefer two tools to control pollution (whether CO2 is a pollutant or not isn't really important; if we want to reduce it, all the economics in this post applies): pollution taxes or tradeable emission permits, the latter of which is also known as "cap-and-trade". If done correctly, these programs will internalize the externality--that is, they will cause the people producing and consuming the polluting goods and services to recognize the costs they are imposing on others.

I've talked a bit about pollution (or "pigouvian") taxes and cap-and-trade before. Both tools are known as market-based regulatory devices because they attempt to alter incentives and let the market do the rest. For example, a pollution tax raises the cost of emitting pollution. If a firm is charged, say, $5 by the government for each ton of pollution emitted, then if a firm can clean up that pollution at a cost of less than $5, it will do so and avoid the tax. It is in the firm's interest to find the cheapest way to clean up, because it will save money by doing so. If it costs more than $5 to eliminate that ton of pollution, then the firm will go ahead and pollute.

How does cap-and-trade work? In the economist's preferred setup, the government would auction off permits, selling for whatever price emerged from the auction. Each permit allows a firm to emit one ton of pollution. Suppose a firm buys a permit for $5, then finds out that it can actually reduce that ton of pollution for a cost of only $3. Now the firm can sell that unnecessary permit to another firm, which can avoid eliminating its pollution.

At this point some environmentalists get confused, suggesting that this means firms can simply buy their way out of polluting. For a particular firm this is true, but it is not true in the aggregate. A particular firm could buy a bunch of permits, which would allow it to pollute as much as it wants. This means that some other firm must be selling permits, however, which means that it must be reducing its pollution. The total number of permits is limited. That is, the government might issue permits for, say, 5 billion metric tons of CO2. Any increase in emissions by one firm must be matched by an equal decrease from another firm. This regulatory method is currently used for Sulfur Dioxide (which causes acid rain as well as health problems) and has been wildly successful, reducing pollution significantly and at a much lower cost than expected.

Both the programs I have described raise revenue. In the first case it is tax revenue, and in the second it is auction revenue. In both these cases firms will have to reduce their pollution, which is costly to them. Higher costs will mean higher prices for pollution-intensive goods and services, such as electrical power from coal plants. The Republicans have been repeating this point over and over, saying that for this reason (higher energy costs for consumers), the cap-and-trade program is a terrible idea.

They have it precisely backwards. Higher energy costs is the primary point of the program. It is supposed to raise energy costs. The reason why this is a feature, and not a bug, is that it communicates to consumers the harm that is done by their purchase of energy that creates CO2. That is, by raising the cost of energy, consumers are induced to buy less of it. If CO2 is harmful--and the strong consensus is global warming is real, and will probably be harmful--then we want consumers to consume less energy. It is as though the Democrats passed a bill to reduce pollution, and the Republicans objected that it would reduce pollution.

Another objection is that reducing pollution may be too costly for some firms, which may shut down. Again, this is a feature, not a bug. Firms which produce goods of such low value that they cannot justify the harm produced by their pollution should shut down.

Finally, another advantage of pollution taxes and cap-and-trade is that they encourage development of cleaner alternatives. Cleaner sources of energy pay less tax or buy fewer permits. This gives them an advantage, and causes dirty energy producers to switch to cleaner technologies. It also causes firms to research new technologies which might be even cleaner still. Best of all, it gives firms a strong incentive to find the best new clean technologies. By contrast, the government has in the past tried to subsidize research into clean technologies, with mixed results. Why have these results been poor? Because the government has little incentive to find the best, lowest-cost ways to reduce pollution, because it has little at stake. By contrast, firms that find fantastic new technologies stand to profit substantially.

One way to make higher energy costs less painful for consumers is to give the revenue collected to them. A simple way to do this would be to use the revenue collected to simply eliminate a tax, such as the payroll tax. This could result in efficiency gains (known as the double dividend), although for complex general equilibrium reasons (having to do with the form of taxation eliminated and the response by consumers to the tax cut), it might not happen. Still, for distributional or for efficiency reasons, it may be desirable to give the money back to consumers.

Here's where a legitimate complaint about the current bill might be made. The proposed cap-and-trade program does not auction off the permits. It simply hands them out for free. It still reduces pollution, and firms can still buy and sell them, and energy prices will still go up, but there is no revenue collected by the government. This is equivalent to taxing the firms for polluting, and then giving them all the tax revenue back. Most economists would prefer that the money be used to eliminate distortionary taxes, or at least to reduce the level of government borrowing. Republicans are not making this complaint. They could also complain that there are inefficiently few permits being issued, but they're not doing that either. They are instead complaining that the regulation might do exactly what it is designed to do. That is confusing and misleading, but I suppose that's politics.

Update: From Greg Mankiw's blog, here are two articles describing legitimate problems with the current cap-and-trade bill. One of the problems discussed is the free distribution of permits (as opposed to an auction) that I mentioned before.

Friday, June 26, 2009

Boudreaux on Globalization and Local production

Don Boudreaux has a great "ask the professor" post on globalization and, even better, the current fad for local production. As far as I'm concerned, there's only one reason to buy locally produced anything, and that's to get fresher fruits and vegetables. The question-and-answer section after the main article is great, too.

Hat tip to Arnold Kling.

Future Imperfect and the Disputed Iranian Election

One of the arguments David Friedman makes in Future Imperfect (which I sort of review here) is that it is hard to know which way information technology will take us--to a panopticon in which the government can watch everyone, or a world in which everyone can easily monitor the government, or both. Would a world in which everyone can watch everyone result in more happiness or less?

The press has been talking a great deal about the use of information technology, particularly twitter, by the protestors in Iran. It has been used to get information to the outside world, and it has probably been used to organize protests. Here is an article, however, which argues that the government can just as easily use this technology to sow confusion and misinformation, or to stifle discussion.

Monday, June 22, 2009

Hot Town, Summer in the City

Finally, the hydrant has been opened! It took them much longer to get around to it this summer.

It's so hot that Charlie is (misguidedly) hanging out on top of the air conditioner.

Monday, June 15, 2009

More on Schooling

Art Carden and I have an op-ed in The Tennessean that was originally based on this blog post. It changed quite a bit, in large part because of space constraints (550 words or less), and also because Art's take on the subject is slightly different--perhaps only in style--from mine. Art's focus is more on getting government out of education completely. The original blog entry focused primarily on vouchers, and on the lack of a compelling argument for having schools operated by the government. I'd like to use this entry to add nuance to the arguments in the newspaper op-ed.

To reiterate the initial thrust of both pieces, there is little reason to think that having the mayor run the schools will result in an improvement in the quality of education. This is not because the mayor is evil or stupid or anything nefarious; it is simply because he is trying to solve a very difficult central planning problem, while facing pressures from various lobbies. Just as when production of cars or food is centralized, the result of centralizing education tends to be a one-size-fits-all, bureaucratic, poorly-run mess. There simply aren't incentives in place that would encourage or even allow the mayor to find the right ways to run a school system. Competition, on the other hand, should help with this problem. We don't need to find the "right way" to build a car; we let many companies build cars, and let consumers decide which ones are right. Firms compete over consumers' dollars, and in so doing try to find new and better ways to make those consumers happy.

Markets are not perfect, but perfection should not be enemy of the good. We're simply not likely to get persistent improvement in schools so long as schools are in the hands of a government-enforced monopoly. The piece in The Tennessean contains the following:
When markets are left alone, people are usually compelled by competition to serve one another in spite of our natural disinclination to do so...
This is simply Adam Smith's invisible hand argument. The idea is that individual self-interest can lead to cooperation and service of others, even if that is not one's intent.

The word "usually" is in there for good reason. There are particular ways that markets can go wrong--negative externalities, such as pollution, or public goods that might be underprovided by the market, such as national defense, as well as other "market failures" that I won't go into here. There may very well be positive externalities from education. That is, there may be external benefits from having everyone able to read--you benefit from being in a society in which I can read, but I don't take that into account when I decide whether or not to learn to read. As a result I may underinvest in education. It seems to be the case, according to Kerry King, that even if these external benefits exist, people would choose to buy enough education to create them anyway. That is, those very basic skills that make for a better society--literacy and numeracy--are likely to be almost universally obtained out of self-interest.

Even if King is wrong, however--even if people, left to their own choices, would not choose enough education--that is not an argument for schools run by the government. It is an argument for subsidizing privately run schools. That is what vouchers do--they are a government payment that can only be used to purchase schooling (the G.I. Bill and Pell Grants were really vouchers for higher education). These vouchers could be restricted by income, although I see little reason to do so. The D.C. voucher program was targeted at low-income families. The result was that a lot of poor, mostly black families were able to send their children to schools of their choice, rather than being locked into their local monopoly. Right now, only the wealthy have that option, since only they can afford to move based on school district quality, or to send their children to private schools.

A concerned neighbor commented via email on my original blog entry, suggesting that the result of vouchers might be that people end up sending their children only to schools with people who are just like them. I agree that this is possible; bigots might choose to keep their children out of schools with black students, for example, or Christians might not want their children associating with heathens. I have several responses to this, however:

1) I don't think this would happen today to the same extent that it would have, say, thirty years ago. It would surely still happen, though.
2) The wealthy already have this option. We currently have a system that allows the wealthy to be bigots, but does not allow the poor to be bigots. The only way to prevent this is to make it illegal for parents to send their children to private schools, make it illegal to home school them, and to somehow prevent them from taking advantage of majority-white school districts, perhaps with busing.
3) I see this kind of voluntary bigotry as offensive, but I think it should not be equated with the government mandated segregation of the past. That is, it is one thing for people to choose to send their children to schools with a particular makeup. It is another thing for the government to force black children to go to black schools. Rememember the children in D.C.: They were poor and mostly black, and they were able to choose to go to private religious and secular schools of varying racial makeups. If it came down to it, I would prefer a voucher system targeted at poor families to no voucher system at all.
4) I would prefer to have students--particularly poor students currently worst served by the system--getting high quality education on a competitive market, even if that leads to some self-segregation, to having students forced into more diverse schools that provide poor education. I admit that this is a value judgement.

A related argument was that some schools might try to keep out black or poor students, perhaps by raising tuition above the amount of the voucher. This is possible, but I think it is unlikely unless parents have a very strong preference for bigotry or classism. Schools do not want to turn down money; I do not think they will turn away the students that go with the money. It is possible that some schools will offer some sort of very expensive education, and may therefore charge tuition that exceeds the amount of the voucher but that would be because of higher costs, not because of racism. Again, I am not saying that such bigoted influence on tuition is impossible; merely that it is unlikely. I am not familiar with such a thing happening with past voucher experiments. If anyone has evidence on the subject, please pass it along.

Finally, the article says that I am a "free-spirited economist"; that was intended to be a humorous euphemism for "unemployed economist". I am currently looking for teaching work in Nashville. I was curious to see if The Tennesseean would keep that in there, and surprised to find that they did.

I have always wondered why op-eds seem so simplistic and one-sided. Now I know: space constraints. Unfortunately, the freedom afforded by a blog probably causes me to go too far in the verbose direction.

Thursday, June 11, 2009

A Question About Happiness

This entry (and the more detailed explanations linked therein) by Justin Wolfers on happiness research and the Easterlin Paradox is interesting. In short, they find that, contrary to previous research, being wealthier does in fact make an individual happier, and wealthier countries are, on average, happier.

This is a study of the relationship between levels--the level of wealth and the level of happiness. I wonder, is there a relationship between the growth of wealth and the level of happiness? A long time ago I read Brad Delong's review of a book by Ben Friedman, in which Delong wrote:

...modern society is a bicycle, with economic growth being the forward momentum that keeps the wheels spinning. As long as the wheels of a bicycle are spinning rapidly, it is a very stable vehicle indeed. But, he argues, when the wheels stop—even as the result of economic stagnation, rather than a downturn or a depression—political democracy, individual liberty, and social tolerance are then greatly at risk even in countries where the absolute level of material prosperity remains high

I wonder if this would show up in happiness data. Has anyone done the simple panel data regression of happiness on growth rates of GDP, rather than per capita GDP?

Update: Thanks to Jonathan nation for a correction.

Sunday, June 07, 2009

Trading One Monopoly for Another

An article in The Tennessean today explains that the mayor of Nashville may be taking over the schools in the district (rather than having them run by elected school board officials). The argument in favor is that it streamlines the system, making it easier for changes to be implemented. Working with a board can be difficult, as competing interests battle for control of the system.

I don't really see why handing over control to the mayor would be an improvement, however. Sure, it eliminates bickering between board members and the interest groups (parents, teachers' unions, and the government school bureaucracy), but without some sort of competitive pressure on the mayor's administration, why would he be able to do any better? All he can do is decisively favor one group, or no group--I see no reason why he would be better able to get things done, and I see no strong incentives for improvement.

Suppose we built our cars like we provide education. We would have local factories, run by the government and paid for with property taxes. What car you would get would depend on where you lived. If you didn't like the car you got, you could move to another area, or go to local car factory meetings (where you must battle the workers' union, which wants maximum wages for minimum effort, and does not want their quality scrutinized, and the government bureaucracy, which cares little about the outcome). You could also buy a privately produced car, but that would mean that you would forego all that money you paid into the property tax system, and you'd have to pay the full price of a private car on top of that. Does anyone think this system would give us better cars? Surely not. It provides choice of cars only for the wealthiest buyers; the rest must consume the cars produced by the local monopoly.

Education is a very complicated good (or if you prefer, a very complicated investment), but I don't think the comparison to cars is unfair. Cars are also complicated bundles of characteristics--fuel economy, acceleration, comfort, appearance, reliability, safety, convenience features--that must be bought together. Some characteristics, such as reliability, cannot be immediately observed. Organizations, such as Consumer Reports, exist which try to collect data on reliability, so that consumers can make informed judgements about the long-term wisdom of buying a particular car. Is education really so different? Surely it makes a great deal more sense to set up a system of incentives that encourages schools to compete to improve quality, in order to attract students, rather than debate which whether we should place the government monopoly under a board's control or a mayor's control. Sure, we might get lucky and elect a particularly motivated, competent school-board director, but what about when he is gone? A system that relies on the public electing brilliant, motivated officials, rather than relentless competition, does not inspire my confidence. A system of incentives is more powerful and reliable in the long-run than a system of "big men".

A voucher system is one such method; give each student a voucher good for some amount of money, and let the student (and his or her parents) spend it on whatever school the student wants. Schools must lure students, and their money, to their doors, by providing education that people want. A common objection to this system is that, because students could choose private schools, this removes resources from the public school system. This is true, but it is also true that this system removes students from the public school system; with fewer students, the public school system does not need as many resources. The evidence on voucher systems that have been tried in the U.S. so far is mixed; the experiments are sometimes short-lived (teachers' unions strongly oppose them), and the lag times involved from input to output may mean we haven't given them enough time. Other countries, particularly some European countries that do better than the U.S. on standardized test scores, use a voucher-like system. (There are other reasons why they may do better on standardized tests, including the possibility that they test fewer of their students.)

Even if vouchers are not a panacea, I nonetheless see no good reason why education must be produced by government schools. Why should we expect the government to be better at producing education than a private institution? If equity or access are concerns, vouchers address them. I can think of a bad reason why government would want to provide education: to indoctrinate. Looking back on my own education, I find it bizarre that I was required to stand up and salute the flag, and in elementary school, we even had to sing The Star Spangled Banner every morning.

Thursday, June 04, 2009

Learning by Doing

Tesla Motors, producer of the Tesla Roadster all-electric sports car (0 to 60 in 4 seconds with a 240 mile range!) has produced their 500th car. Their next product will be an electric luxury sedan at a significantly lower price than the $100,000 Roadster.

Aside from being an interesting example of technological change, this story is interesting because it's an example of what economists call learning effects, or learning by doing. It took Tesla Motors eight months to produce the first 100 Roadsters. The next 400 roadsters took only another eight months. Some of that is probably due to increased capital, but a lot of it surely has to do with simply getting better at what they're doing through practice. The most famous example of this is the production of weapons and vehicles during World War II, during which factories found that they could rapidly expand their production, producing more planes, faster, and at lower cost, simply because workers learned more efficient ways to do their jobs.

These sorts of gains are one reason why we should be optimistic regarding the production of alternative energy vehicles. They may be expensive now, but they will get cheaper with time. It is true that some inputs--such as lithium for lithium-ion batteries--are very scarce. They may even get more expensive. This isn't an insurmountable problem, however. Julian Simon pointed out that there is more than one way to make wire for communications when copper becomes scarce. One way is to find more copper. Another is to come up with a substitute, such as fibers that transmit light. The substitute may even be better than the original. The more scarce the original resource becomes, the more pressure there is to find an alternative, and the more profitable such a discovery becomes. Recycling old resources may also be an option, if the recycling process is not itself too resource-intensive.