Common Tragedies

Thoughts on Environmental Economics

The Hayek club

Posted by Daniel Hall on December 5, 2007

There’s an interesting discussion going on in the blogosphere about what might constitute a conservative response to climate change. This got started by Jim Manzi’s argument at the American Scene against a carbon tax (actually any emissions pricing policy, whether a carbon tax or cap and trade), and in favor instead of a surge in technology development funding. Ryan Avent has responded at Gristmill (and on his own blog) that we can and should price carbon, and notes that it is odd that Manzi, a conservative, is arguing for an “approach to emissions reduction that favors the wisdom of central planning over market allocations,” (i.e., technology development over an emissions pricing policy).

Manzi has written a subsequent post that clarifies his reasons for opposing a carbon tax, and they essentially boil down to this: “It’s complicated! We won’t get it right!” To defend his opposition to a Pigouvian carbon tax he invokes Ronald Coase:

Ronald Coase’s lecture upon receiving the Nobel Prize in economics is very instructive. When discussing one of the two papers for which he won the award, The Problem of Social Cost, he had this to say:

I was exposing the weaknesses of Pigou’s analysis of the divergence between private and social products, an analysis generally accepted by economists, and that was all. … Pigou’s conclusion and that of most economists using standard economic theory was, and perhaps still is, that some kind of government action (usually the imposition of taxes) was required to restrain those whose actions had harmful effects on others, often termed negative externalities. What I showed in that article, as I thought, was that in a regime of zero transaction costs, an assumption of standard economic theory, negotiations between the parties would lead to those arrangements being made which would maximise wealth and this irrespective of the initial assignment of rights. … I tend to regard the Coase Theorem as a stepping stone on the way to an analysis of an economy with positive transaction costs. The significance to me of the Coase Theorem is that it undermines the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances. Of course, it does not imply, when transaction costs are positive, that government actions (such as government operation, regulation or taxation, including subsidies) could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My conclusion; let us study the world of positive transaction costs.

Manzi goes on then to claim that what with transaction costs being so large an emissions pricing policy just won’t work. I think he overplays many of of the practical difficulties, but since Ryan’s post anticipated many of these arguments I’ll leave you to read it.

I want to object rather to Manzi’s disingenuous intellectual sophistry in ignoring the actual message of Coase’s quote. Plainly read, Coase is arguing that Pigou’s externality-solving tax is unnecessary when transaction costs are zero. However, a world with negative externalities and positive transaction costs — and there surely will be some transaction costs to any emissions pricing policy, even if I think Manzi exaggerates them — is exactly a world where the government is needed to intervene in order to produce the socially optimal outcome.

To be fair, Manzi does, after all, want to intervene; it’s just that he thinks we’ll be better off if the government intervenes to support technology development rather trusting that a pricing policy will optimally allocate emissions-generating activities towards their highest value uses, and gradually transform the energy-using system through the invisible hand. To paraphrase Ryan, this is a “conservative” position? Manzi shouldn’t get to so cavalierly dismiss the feasibility of pricing emissions without having to explain how the government is going to be able to pick exactly which emissions-reducing technologies to develop.*

Manzi’s mistrust of the ability of prices to effect fundamental changes in our energy systems flies in the face of another strong free-market advocate, Friedrich Hayek, who wrote about the miracle of disaggregated decision-making in his essay “The Use of Knowledge in Society“:

Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people in the same way as subjective values help the individual to coordinate the parts of his plan. It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose—and it is very significant that it does not matter—which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all his without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity—or rather that local prices are connected in a manner determined by the cost of transport, etc.—brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.

Substitute “carbon” for “tin” and you have a superb, concise explanation of why an emissions pricing policy will be the most effective approach to reducing emissions. Count me as a member of the Hayek club.

*This blog has been absolutely insistent in arguing that there are strong economic justifications for investing in technology R&D that have to do with the positive spillovers that are generated by innovation. Because investors cannot privately capture the entire social benefit of their innovations — indeed, research suggests the social returns to innovation may be four times the private returns — the government should subsidize R&D, and in particular fundamental R&D (rather than deployment policies, which tend to be preferred by lawmakers who need to buy off special interests). However, this does not at all imply that an emissions pricing policy is not needed as the central feature of a cost-effective approach to reducing GHG emissions.

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5 Responses to “The Hayek club”

  1. S. Salyer said

    Interesting stuff. But I was really disappointed that the Hayek being talked about wasn’t Salma.

  2. Jim Manzi said

    Daniel:

    Thanks for your thoughtful and intelligent comments on my post. It’s always great to see Hayek quoted!

    I wasn’t trying to mis-apply Coase’s observation. I would paraphrase what I think he was saying as ” We don’t need Pigovian taxes in a situation with zero transaction costs, but just because we are in a situation with postivie transaction costs, that doesn’t mean we should resort to such taxes. We should evaluate the costs and benefits of proposed taxation to correct externalities in light of how real, not imaginary, governments behave.”

    In this case, I think that the future AGW-avoidance benefits (which are real) don’t justify the costs in terms of lost consumption today of pushing investment and consumption decisions away from fossil fuels using a tax or cap-and-trade system. (The first post made this argument).

    The point of the post that you reference was merely to rebut the idea that a carbon tax doesn’t offer a free lunch – to make the point that the costs against which I am comparing the benefits are still real.

    I support investment in technology in this area as, primarily, an insurance policy against more-severe-than expected AGW impacts.

    By the way, I yield to no man in my admiration for Hayek and the idea of prices as information. In fact, this is one of the most insidious effects of a carbon tax: if large enough to be effective, it would among other things largely destroy the information content of energy prices.

    Again, thanks for taking the time to read and comment in such detail.

    Best,
    Jim

  3. Nick said

    Any post that cites Coase and Hayek is a winner in my books. But, I’d strongly suggest one other reading:

    Demsetz, Harold (1969). Information and Efficiency: Another Viewpoint. Journal of Law & Economics, Volume XII (1), April. Pages 1 – 22.

    Specifically, in response to “..is exactly a world where the government is needed to intervene in order to produce the socially optimal outcome.”

    As Demsetz argues, too often we see market failures (unpriced GHG externalities) and jump to the conclusion that governments can do beter – without understanding the likely government failures. The “Nirvana fallacy” is that government failures will necessarily and always be smaller than existing market failures.

    In the climate case, I do think government intervention could improve social welfare, but Demsetz reminds us to look at the real world, not a utopian view of government.

    Looking at over-allocation in phase I of EU ETS, suspect CDM credits all over the place, a lot of wasteful subsidy programs under the guise of climate protection measures, and various carbon taxes that have been so small (Quebec) or exempted key sectors (Norway) leaves me a bit more humble about what successes are possible through government intervention.

    In summary: Yes, price carbon – but don’t expect miracles.

  4. Daniel Hall said

    Nick:
    Thanks for the pointer to Demsetz. It’s an excellent point.

    Jim:
    Thanks for commenting. I apologize your comment didn’t appear right away; for some reason our spam filter had nabbed it and I had to manually retrieve it this morning at my daily spam check.

    I’ll concede that — as Demsetz argues in the paper Nick references — government intervention may not necessarily make us better off than just living with existing market failures when considering the real world. The question then becomes which account of the real world is more convincing: yours or Ryan’s. My views don’t exactly match either account, but lean much more towards Ryan’s. I leave readers to decide for themselves which they think is most plausible.

    I certainly agree that an emissions pricing policy is not a free lunch, but I think you are entirely too glib about how far we can expect to get with a technology-only policy, a point I elucidate in my subsequent post.

    And despite your avowed respect for Hayek, I remain somewhat dumbstruck by the fundamental mistrust of prices that permeates your pieces at The American Scene. Your focus is entirely on the (admittedly large) uncertainties that exist about how to set a price, what it should be, and whether it would work; you never move beyond this to discuss — as I think Ryan does quite well — why an emissions price is the most robust and efficient policy instrument in the face of uncertainties.

    Finally, I must respectfully disagree that a if carbon tax was “large enough to be effective, it would among other things largely destroy the information content of energy prices.” A recent analysis from MIT modeled U.S. cap-and-trade proposals. Even under its most stringent policy scenario — more stringent than the Lieberman-Warner bill now moving through the Senate — they found electricity prices in 2030 would be about one-third higher than in the business-as-usual scenario. This is no free lunch — but it is hardly overwhelming the underlying energy prices.

    Joe Aldy at RFF summarized this research at MIT and other modeling work from the Energy Information Administration in a paper that is part of RFF’s new report on options for U.S. climate policy. I commend it as further reading for those who are interested in this topic.

  5. Jim Manzi said

    Daniel:

    Thanks for posting my comments. A few quick points:

    1. I read your subsequent post, and I agree that the idea that carbon taxes will actually depress innovation sounds pretty silly. In fact, in one of my earlier articles, I proactively asserted that a carbon tax would “work”, but that it would just be insanely expensive.

    2. When thinking about worldviews, consider the following. If we accept Nordhaus’s modeling (for the sake of argument, and I think any realistic model will find directional agreement with the following), then total AGW costs are expected to be ~1% of PV of future consumption. We should just let 75% of these costs happen because abatement is more expensive than the costs themselves. Think about that. Further, if we assume a “perfect” implementation of a carbon tax, we end up with a net benefit of abatement of 0.17% of PV of consumption. (Let’s mutually agree that these are all ridiculous degrees of asserted precision). So another way of asking the question is: do you think it’s realistic that the “costs” (e.g., side-deals to get Russia to agree, subsidies to US coal miners and truck drivers, failure to get China to actually enforce any agreement, etc.) would be less than 0.17% of PV of future consumption. I think it’s a great bet that they will.

    Further, this actually over-states the expected incremental benefits of a carbon tax if we consider the net reduction in expected costs over-and-above the benefits of a technology investment program.

    3. My header for the section of the post on setting the price probably didn’t communicate the point well. It’s not just that it’s hard to measure expected AGW costs, or that it’s unrealistic to think that Ways and Means will actually be guided by academic analysis (though I think both of these things are true). It’s unclear to me, since we can’t measure the external costs (including AGW plus everything else) of carbon and non-carbon-intensive fuels within an order of magnitude, how we can engage in trial-and-error learning. How will we know whether we have decreased or increased total external costs once we have shifted X units of production, say, from LNG to biomass? I think this is the opposite of mistrust of prices; it is abhorrence at the idea that they be politically managed.

    Last, I attended a recent presentation by Joe Aldy on this topic, and can endorse the idea that it is very valuable to hear what he has to say.

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