Costs and benefits of government regulation

In our brief study of market failure we arrived at government intervention as a general solution. Because the market fails to produce the outcome that is best for society on its own, some form of "regulation" of the market is necessary to achieve the socially efficient result.

The imposition of performance standards or technology standards, Pigouvian taxes on negative externalities, the establishment and enforcement of property rights ala Coase, and administration of tradable permit systems (cap & trade) are all examples of regulation.

Importantly, in cases of market failure, regulation is intended to promote economic efficiency - making the size of the "economic pie" larger allows everyone to have a larger slice (at least in theory). Yet "regulation" is often considered a dirty word, and associated with less economic growth. "Deregulation" likewise is often viewed as promoting efficiency. Clearly, there's an argument to be made from both sides of this messy issue, and the realized outcome likely depends on the source and nature of the market failure and government's ability to correct it.

In light of notable recent events, Steven Pearlstein of the Washington Post calls for consideration of not only the costs of regulation, but also the benefits in terms of protecting the public interest and productive natural capital. This is obviously a controversial issue, but this article makes for an interesting read.

Sustainability?

Big topic. Messy topic. Political topic. Potentially ugly topic. Let's keep it objective please...

Sustainability goes beyond natural resources to include human wants and needs. That is, the notion of sustainability includes economic sustainability. People value the environment, but people also value goods and services and their standard of living. We know that imposing Pigouvian taxes (e.g. a carbon tax) or standards (e.g. mandates on allowable technology) or a combination policy (e.g. 'cap and trade') will increase firms marginal cost and increase the prices of goods and services. In other words, if you want a cleaner environment, you're going to have to pay for it. Note that "pay" here could include opportunity costs - you can have more X if you give up Y, and Y doesn't have to be dollars. I hinted at this idea in the first lecture, when I asked if you think the environment is "priceless" and then I asked what kind of car you drive (if you truly felt the environment were priceless, you wouldn't drive any car).

Joel Kotkin of Forbes has an interesting article titled "The limits of the Green Machine", where he discusses these issues and the political viability of environmentalism. His basic thesis is that pushing for too much environmental protection would be a mistake (especially during an economic downturn), because people just aren't ready or willing to give up their way of living.

Thoughts? Again, I'm not looking for normative opinion here.

How does this idea fit in with the lecture readings on common property/public goods?

Clean up costs and lost value

OK, so it seems fairly obvious that the economics of the recent oil spill can be explained using externality theory. A market creates a cost realized by a third party, and that cost is not reflected in the market price of the good. As such, the market outcome is inefficient in the sense that total net gains to society are not maximized.

My last post was an attempt to get you to think about how a single, accidental imposition of costs onto a third party might be different than a continuous release of pollution from production or consumption, and to consider how Pigouvian taxation may or may not apply in cases of a "one time" release of pollution. To get you to think about it a bit more, here's a follow-up question:

How much should responsible the responsible party pay in these situations?

For context, check out this short article from CNN Money on the clean-up costs associated with six big oil spills.

Background reading:

CERCLA and Superfund from the US EPA

The Oil Spill Liability Trust Fund from the US Coast Guard

Is the Deepwater Horizon spill an externality?

It seems to have the characteristics of a negative production externality:

The market for petroleum creates a negative effect (putting it very mildly) on third parties. This cost is not incorporated into the producer's supply curve and as a result is not reflected in the market price of petroleum products. As such the market price and quantity of petroleum can be considered inefficient. That is, the market outcome does not result in maximum gains to society.

So, does Pigou's solution to negative externalities apply here? If so, how would it be put into practice?

A hint...

The question about pros and cons of the anthropocentric view of value always generates a lot of discussion and hand-wringing. It seems like a philosophical question, so students tend to search for deep meaning. What I'm looking for is fairly simple, but I don't want to give it away.
Here's a hint from today's local paper.

Supply & Demand, N.C. Oysters and Oil

From the Raleigh News and Observer.

Yep. Supply and demand in action. Supply shifts back, price goes up.

What should happen to the price of farm-raised oysters, if anything?


Hat tip: env-econ.net

Moral Hazard, Liability and Oil Spills

At the end of my junior year at UNCW, the Exxon Valdez ran aground in Prince William Sound, Alaska. The biological and economic damage was nothing short of catastrophic. 20 years later... here we go again.

It's a stretch to say that anything good comes of disasters like these, but Valdez gave us the Oil Pollution Act (OPA), and considerably tighter standards on shipping. Valdez also greatly accelerated the use of non-market valuation methods, especially contingent valuation (CVM), advancing the science and practice of economic valuation at speeds that would have not occurred otherwise. We'll study CVM in lecture 4. You can read about some of the value estimates here at the Encyclopedia of Earth entry for the spill (scroll down to the section on "economic impacts").

The Gulf Coast spill should have similar legal repercussions. Of particular interest is the legal cap on liability. OPA limits liability to $75 million, which was a lot of money in 1990, but seems far too low today. The White House is already pushing for the cap to be removed, but as good students of economics, we have to ask if things might have been different had the cap been changed earlier.

The topic here is "moral hazard" and it's one that has been in the news a lot lately (bank bailouts). Basically, if you have really good insurance (coverage against loss), you're more likely to engage in risky behavior. In the context of the Gulf Spill, if the responsible party were liable for 100% of the damages (with no maximum), would they have taken more caution than if their liability were limited?

Here's a long quote that addresses the point:

"If the consequences of one's actions are felt only by one's self, one will take optimal precautions to avoid accidents. Economists predict that a rational person will invest in accident avoidance just enough resources so that the marginal cost of accident avoidance equals the marginal benefit of accident avoidance. This minimizes the total of the two costs: the cost of accidents plus the cost of precautions.

In the case of accidents that affect others, the individual's incentive to take precautions is not optimal, unless the liability system acts to "internalize" the costs of accidents. Various liability rules (such as strict liability, negligence, and no fault) affect people's incentives to take economically appropriate precautions. If people know that they can be held responsible for some or all of the costs or damages sustained in an accident, they will change their behavior to make the accident less likely to occur or to reduce the damages should it occur.

Some liability systems produce too much precaution; others produce too little. An excessively cautious individual may reduce the chances of an accident to zero by staying home in bed all day, but the cost in lost income would be very high. Similarly, a liability system that yields too much precaution may lead manufacturers to produce the only perfectly safe airplane--one that never leaves the ground.

Conversely, if the liability system did not allow people involved in automobile accidents to sue the responsible party for damages, drivers would have less incentive to be careful. The actions people take every day indicate that individuals and society accept the riskiness of some activities. Eliminating all risks, if possible, would be overly cautious.

Any liability system that seeks to optimize the trade-off between the costs of accidents and the costs of preventing them must take into account, among other things, all the costs associated with accidents. If some important category of costs is ignored by the system, individuals will tend to take too little precautionary action. By the same token, if the system exaggerates the costs, there will be a tendency to take too much precaution"

It is interesting to note that this was written in 1995, in a book titled: "The Economics of a Disaster: The Exxon Valdez Oil Spill" by Argue, Furchtgott-Roth, Hurdle, Mosteller, and Owen.

Seems pretty timely now too.

Thoughts or questions?

Applying basic supply and demand modeling, what kinds of effects do you think we'll see in the wake of the Gulf spill?

Welcome Summer Class

Welcome all.

This purpose of this blog is to facilitate discussion for students of natural resource economics at UNC Wilmington.

I'll post questions for discussion and tips to relevant news and on-line material throughout the semester. My goal is for us all to learn from each other.

Best,
-PS