February 26, 2008

Economics is tricky II

Okay, let's talk about externalities. In a nutshell, an externality is something -- good or bad -- that you don't pay for. For good reason, the examples that always seem to get trotted out are instances of pollution. For example, without the EPA around to correct things, a factory that pollutes a river generally doesn't have to pay to clean up the river. Either the state, and hence the taxpayers, do, or no-one does, and the people living downstream `pay' for the pollution by getting cancer and dying.

The contemporary environmentalist's favourite examples of externalities are `cheap' fossil fuels and `cheap' beef. Both are `cheap' because the cost -- as in, dollars the oil baron/cattle baron pays -- to procure these goods (in the economist's sense, not the ethicist's sense) is much lower than the selling price -- what people will pay to consume them. But, in the quantities which we consume and produce, respectively, both fossil fuels and beef release horrendous quantities of greenhouse gases. Fossil fuels release carbon dioxide, as per Part I, and cows release methane as waste (as well as consuming even more fossil fuels, using up lots and lots of water, and so on).

And yet, because these costs are externalized, it is rational (again, in the economist's sense of maximising one's self-interest) for people who can produce fossil fuels and beef to do so. Which is where carbon taxes and cap-and-trade schemes come in. Since carbon taxes are simpler (cap-and-trade schemes amount to a market on carbon tax thresholds, and that means the analysis is an order of magnitude more complicated), I'll focus on those. From an economic point of view, the idea is quite elegant: if emitters of carbon dioxide (and other greenhouse gas compounds, eg, methane) are required to pay at least a significant fraction of the externalized costs, they will generally shift production to processes and products that emit that much less carbon dioxide. It's no longer rational for (former) carbon-emitters to emit carbon.

I'd also like to argue that carbon taxes can be justified on libertarian grounds. This seems entirely straightforward to me: for every metric ton of carbon dioxide you release, you do US$12 of harm to everyone else. (IPCC report, summary for policymakers, 24) Rather than collecting these damages individually and retroactive to the damage suffered, it makes far more sense (in terms of avoiding the legal costs of everybody suing everybody else) for the state to collect them proactively, and hence use them as a deterrent.

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