Sunday, August 31, 2008

Internalizing Costs

This is the first of what I expect to be many references to internalizing costs. Without going into too much detail on the process of representing environmental cost into prices, I would like to summarize why such internalization is necessary. Contemporary economics, as influenced be Adam Smith, David Riccardo, and so on, grew up in an earlier time, a better time. Man-made capital was the limiting resource, and the idea that natural capital would ever be scarce was absurd. Today most environmentalists (and several key economists) have realized that natural capital is finally the more scarce of the two rudimentary types of capital. However, the price system that governs a market economy barely incorporates "natural capital" unless that capital is harvested, mined, or otherwise arranged in a commodity form--and even then most of the cost is in the labor needed for the extraction. The costs of lost ecosystem services, pollution, or less tangible environmental damage is usually paid indirectly--and as in the case of most external costs, inadequately and irresponsibly--through government spending of tax dollars.

The libertarian in me asks, "Why not internalize the costs and allow market forces to inspire sufficient environmental responsibility?" Scientists have devoted their careers to estimate the value, in dollars, that a particular ecosystem is worth to society. The commonly cited "economic trivia", if you will, is that the biosphere provides twice the global economy in services such as water filtration, pollution management, and crop pollination (among thousands if not millions of others). So the value is there, but how do we internalize it?

So the question becomes a "How do we represent these costs in our prices?" And where I'm stuck is exactly how marginalization breaks down regarding an ecosystem service. Ecology would suggest that a certain amount of exploitation can be sustained before a threshold is reached, though ecologists argue that knowledge of that threshold is unattainable. The overall value of the ecosystem can be gaged, though I'm skeptical that approximating average total cost as the marginal cost would work with many key issues. For example, carbon emissions might contribute only a minor environmental cost early on but eventually reach infinite environmental cost (and for those non-math majors, the average cost is going to end up being "infinity over total units", or... infinity). How can this be resolved?


lindsay41205 said...

yes, i read your article. it's wonderful.

At the end of your second paragraph, you wrote "their" instead of "there".

you're welcome. from lindsay.

Zachary Piso said...

No I didn't

lindsay41205 said...

You just changed it. Obviously.

Tim Moreland said...

If one wants to internalize the costs of environmental damages, then you have to find the "socially optimum" level of environmental damage (yes, it is weird to think of a desired amount of damage, but it exists). From there, the government must tax the product so that the price of the item is at the point where the marginal cost + tax equals the marginal cost to society. Obviously, the problem lies in determining the social cost as separate from the private cost. Unfortunately, it is up to politicians to determine this level and they have way too many political influences to perform an objective, scientific treatment of the situation.

On top of the difficulty of allowing the government to select a tax rate, the effects of reducing domestic demand of environmentally damaging goods may have unintended consequences around the globe. For example, if the United States imposes a tax that decreases the demand of oil, then the world price of oil will drop. With this drop in oil prices, a developing country such as India may buy more. In sum, the environmental damage shifts from the United States to India, perhaps increasing if India has inferior technology that creates more pollution per unit of oil used.

One could argue that environmental damage is taken into account by consumers far more than assumed. For example, someone shopping around for a car will value a high MPG car and thus pay for fuel economy even when it is more "rational" to buy a cheaper car with lower fuel economy. Studies have shown that consumers value MPG more than the actual savings in gasoline. Therefore, it would be false to assume that there exists no workings in the market to allow for the cost of environmental damage to be accounted for.

Bottom line, I am not sure of the best way to internalize costs other than a Pigovian-style tax, but I am also not sure that it would be beneficial for the environment or our economy to reflect this cost in our current prices.

Tim Moreland said...

sorry, i meant to put this email at the end of the last one:

Zachary Piso said...

What if doing nothing isn't an option? You rather consistently argue for laissez faire, and I'm supportive of that in most situations. But it relies on the assumption that thing are fine the way they are going, which most environmentalists would staunchly disagree with. The facts are pretty simple regarding climate change, so I'm going to take a very small "leap of faith" (by which I'm saying, not a leap at all, but rather shuffling along with my argument firmly grounded) and say that doing nothing is not an option.

I very much like the point that lowering our demand causes prices to drop, which in turn rising Asian demand precipitously. I'm hoping someone with a bit more knowledge can predict the net result of such a heterogeneous demand.

I don't want to go into the slippery slope of interventionism, but someone come up with a better solution than the following: "Buy, but not consume, as much oil as we can possibly store, thereby rising the price of the commodity but decreasing it's consumption". And of course I'm not truly suggesting this, but playing Devil's advocate.

Pete Abbate said...

In the perfect fantasy world that is my imagination, the best thing we could possibly do is develop renewable energy technologies quickly, then mass-produce them so that using them will be cheaper than using oil for countries such as India and China. That's really the only way to ensure that American progress is not offset by increased consumption elsewhere in the world.

To make this happen, what we would essentially be creating is a huge American subsidy of the developing world. Sound expensive? Well, I guess we could just keep throwing trillions of dollars at takeovers of small countries...

Sorry for the political commentary there. But such a subsidy does make sense if you believe that much of the environmental damage that exists today is the result of American, I won't call it irresponsibility, but growth and development. If you believe that because of America's choices in the past, we simply cannot allow India and China to develop using the same methods and technologies we did (because the environmental damage would be irreversible), then you supporting a campaign to increase renewable energy technology paid for by Americans makes a lot of sense.