Convincing arguments, bad economics
Posted by Rich Sweeney on September 21, 2007
This is the first in what will probably be a long string of installments describing (and hopefully debunking) arguments that sound reasonable to the lay person, but that fly in the face of widely accepted economic theory. I was originally going to call this series “Arguments rent seekers make”, but I decided to be less cynical. However, it is important to note that this is more than just some snotty academic exercise. Voters’ and policymakers’ susceptibility to these types of arguments leads to suboptimal policy outcomes and inefficient transfers of wealth. At RFF we spend a lot of time explaining (and re-explaining) the fact that “common sense” and a rational examination of actors’ incentives do not always yield the same conclusions. Maybe documenting examples of this will save all parties involved time in the future.
Ok. Today’s example is a simple one, and it has been explained many before in the popular press and blogosphere. Nevertheless, a lot of intelligent, well intentioned players in the carbon regulation arena still don’t quite get it. Do you?
Several eastern states have agreed to cap carbon emisions and now they’re working out the details of the program (it’s the Regional Greenhouse Gas Initiative, in case you’re interested). One of the main points of contention is whether pollution permits should be auctioned off or given away for free to electricity generators. Generators have been telling politicians that if they have to pay for permits, this cost will be passed on to end users. Therefore, they argue that if politicians want to keep electricity prices down, they should give the permits away for free.
Why is this line of reasoning incorrect? Assume competitive, deregulated electricity markets. And, for now, ignore any considerations of what the states could do with the auction revenue they receive. I’ll give my explanation in the first post.