The Law of Demand

According to a recent University of Michigan transportation study, the average carbon emissions per vehicle decreased 3 percent from October 2007 to April 2009. How did we achieve this emissions reductions? Cap and trade? Command and control regulations? No, the reduction instead occurred as consumers responded rationally to higher gas prices.

As a result of higher gas prices last year, consumers bought vehicles with better fuel efficiency and drover fewer miles. Thus, on average, each driver emitted less carbon. This is exactly how a carbon tax would work. The government levies a Pigovian tax roughly equal to the social costs of pollution and lets the market take care of the rest. As gas prices rise, people drive less and choose fuel efficient cars.

Unfortunately, the current administration seems to think that byzantine fuel economy standards will do the trick. But such standards are much more amenable to rent-seeking behavior. This is clearly demonstrated by the fact that the announced standards are favorable to light trucks, which benefits American producers but hurts the environment.

How Far Should We Take Paternalism?

In a Wall Street Journal article, Todd Zywicki highlights an analogy made by Elizabeth Warren, a Harvard Law professor:

[C]onsumers cannot buy a toaster that has a one-in-five chance of exploding, but they can get a subprime mortgage that has a one-in-five chance of ending in foreclosure.

I see one big problem with this analogy. A toaster would explode because of shoddy manufacturing - unless, of course, you have a child who puts his toys in the toaster. It is the manufacturer's fault when the toaster explodes.

On the other hand, in almost all cases mortgages end in foreclosure because of consumers' mistakes. It is not the bank's fault that the mortgagee lost his or her job (speaking of any single bank), it's not the bank's fault the mortgagee used too many credit cards, it's not the bank's fault the home lost value, and it's not the bank's fault mortgagees bought multiple investment homes. Consumers lived on credit because government tax breaks and low interest rates gave them a strong incentive to live accordingly. A foreclosed mortgage is nothing like an exploding toaster.

To be fair, many mortgage brokers were disingenuous in how they presented loans. I'm thus in favor of behavioral economics-type disclosure regulations. But I don't think the government should, in this case, impede freedom of contract. As Zywicki writes:

Treating all consumers as hapless victims rather than recognizing that many consumers rationally respond to incentives is a recipe for unintended consequences. It can lead to counterproductive regulation that makes loans more expensive and harder to get.

More on Waxman-Markey

Over at the National Review, Stephen Spruiell and Kevin Williamson list their top 50 reasons for voting against the Waxman-Markey climate change bill (tip: Volokh Conspiracy). (I'm on a roll with global warming posts - earlier posts here and here.) I agree with much of what they write, but there's a number of points with which I disagree. Also, their first reason displays a stunning ignorance of economics:

1. The big doozy: Eighty-five percent of the carbon permits will not be sold at auction — they will be given away to utility companies, petroleum interests, refineries, and a coterie of politically connected businesses. If you’re wondering why Big Business supports cap-and-trade, that’s why. Free money for business, but higher energy prices for you.

There are two reasons this is bad economics. First, as the Coase Theorem points out, if there is an externality problem (say, excess pollution) and transaction costs are low, private parties will bargain to an efficient level of the externality. Furthermore, the end result is independent of the initial property right delineation - ignoring income effects. If polluters receive the right to pollute, pollution recipients will pay polluters to reduce their emissions, and if polluters do not have the right to pollute, they will pollution recipients to allow pollution. Either way, according to the Coase Theorem, the same level of pollution will result.

The Coase Theorem cannot solve the climate change problem, however, since transaction costs are too high (transaction costs are the costs of reaching an acceptable agreement). Thus cap-and-trade schemes are a way of lowering transaction costs. The government presumably sets the cap at pollution levels that recipients would bargain to, and, in theory, the scheme enables polluters to reduce emissions at the lowest possible cost.

Anyway, whether the government auctions off the permits or gives them away, the same amount of pollution will be eliminated. The only difference is that auctioning the permits grants the government a windfall revenue increase, and giving them away grants businesses a windfall. Given that we are in a recession, I don't think that granting businesses a windfall is such a bad thing.

The second display of poor economic reasoning is the claim that although Waxman-Markey will be "free money for business," it will lead to "higher energy prices for you." This sentence is not even internally consistent. If businesses actually made money by receiving permits, why would they charger higher energy prices? Businesses typically lower their prices when they are profitable.

Many commentators have said that Waxman-Markey will lead to higher energy prices. This will happen only as the government lowers the cap and forces businesses to buy permits or to implement pollution-reducing technology. And this probably won't happen for a few years. If the government made polluters buy permits, price increases would be more immediate.

Happy Belated 4th!

Although many of my posts deride bad government decisions, I was yesterday reminded of how grateful I am for our country. Many people are critical of America, but "our worst critics prefer to stay."

Thank you to all those who labor in service of our country. God bless America!