Bastiat’s Bastions

Many on the conservative side have had many negative things to say about the “Cap and Trade” system.  It should be pointed out that “cap and trade” itself, is not  the source of their ire.  Rather, many conservatives do not like limitations being placed on CO₂ emissions in the US. 

What is this “Cap and Trade” system that is being implemented in the new climate change bill?  Cap and Trade is merely an approach to regulating emissions, and it is one that efficiently reduces those emissions.  It contrasts with two other approaches: one that is called the “command and control” approach to regulation and the other is an approach that taxes emissions, such as the proposed “carbon tax” to regulate greenhouse gases a decade ago.  Before looking look at these regulatory systems, let’s look at the ideal environmental regulatory outcome.

At first glance, it would seem that no pollution would be the best regulatory outcome.  Think of what this would mean when we consider CO₂ as a pollutant.  We inhale oxygen, but if CO₂ is a pollutant and we want no pollution, then, we better hold that breath.  But we cannot.  Stopping all pollution is just too costly. Anything we do to reduce our pollution will cost us something. But, of course, pollution itself is costly, either health costs, or aesthetic costs, or costs in losses of biodiversity. The ideal, then, is really to keep the total costs of pollution and the costs of reducing that pollution to a minimum. 

Generally, each extra ton of emissions of CO₂ causes the added costs of pollution to increase.  Also, if we look to reducing CO₂ emissions, we can find some inexpensive ways to cut emissions, and after we cut emissions in those ways, to cut emissions further, we would have to employ costlier and costlier means.  To keep these total costs to a minimum, the added costs from cutting a ton of CO₂ emissions have to equal the added costs of the damage done by another ton of CO₂ emissions.  If the added costs are higher from the damage done from another ton of CO₂ than from cutting emissions, we could lower total costs by cutting emissions.  On the other hand, if the added costs of cutting emissions by a ton are higher than from the damage done from another ton, total costs could be lowered if we go ahead and pollute that ton.  The “right amount” of pollution, then, is the amount where another ton would cause costs of cutting pollution by the same amount as the costs of the damage done by another ton of pollution.

Of the three methods of pollution control to understand, the easiest to understand is the “command and control” system.  Here, the regulatory commission sets requirements for each source of pollution, monitors them for compliance, and then sets fines and punishments for those who fail to comply with the regulatory requirements.  Here, possible polluters just do what they are told or face extremely high fines or other punishments.  The “command and control” name for this regulatory type comes from the management form used in the military.  Historically, most of regulation of the EPA has been of this “command and control” type.  The best way of thinking about this approach is to recall the lines from Tennyson’s “Charge of the Light Brigade:”

Theirs not to make reply

 Theirs not the reason why

    Theirs but to do or die.

 This command and control system of regulation does not do a very good job of keeping costs of regulation down, nor does it do a good job of balancing the costs of damage with the costs of reducing emissions.  The regulatory authority just does not have information on all of the costs.  This information is mostly diffused throughout the society—various electric power generating companies have a good idea of what their costs of cutting emissions are like, so a lot of people have bits and pieces of this information, and no one knows it all. 

One of the earliest regulatory suggestions for reducing the costs of pollution control was made by A.C. Pigou in 1920 in his book, The Economics of Welfare (with the word “welfare” meaning “wellbeing”).  Pigou suggested that a tax could be levied on certain activities, such as pollution, that would give people an incentive to reduce those activities.  Economists in the 1960s and 1970s saw that such a tax would get polluters to reduce pollution in a least-cost way.  Any producer who could reduce emissions at a cost below the tax would do so, while those who could only cut their emissions at a higher cost would not.  Suppose the tax on emissions is $100 per ton.  All pollution reduction that costs more than $100 per ton will not take place, but pollution reduction that costs less than $100 per ton will take place.  Lower cost cleanup activities replace higher cost cleanup and costs cannot get any lower.

A little later on, economists came up with a slightly different approach.  The environmental regulatory authority would first decide how much emissions would be allowed, create “pollution rights” which would be tradable.  Polluters who could reduce pollution very cheaply could then reduce their emissions and sell their rights to those who could only cut their emissions at a very high cost.  If the price of a pollution permit were higher than the cost of cutting emissions, the producer could then reduce their emissions and sell off their permit.  If the emission permit sold for a price below the cost of cutting pollution, the emitter would buy up permits.  If you think that such a scheme is unworkable, think again.  We have been using tradable permits of this sort to control SO₂ emissions that cause acid rain since the 1990s, and these permits trade on the Chicago Board of Exchange, along with various commodities.

The Pigou tax on pollution, which we saw a decade ago called a carbon tax, gives polluters a constant price to respond to, and the total amount of emissions could be higher or lower and can change over time.  If the costs of cleaning up go up, we end up with higher levels of emissions.  On the other hand, the tradable permits system produces a constant level of emissions but with a price of pollution that varies.  Both of these methods minimizes the costs of cutting pollution because both produces a price for cleaning up so that those with costs of cutting a ton of emissions above that price do not cut their pollution and those with costs of cutting a ton of emissions below that price do cut emissions.  Only the low-cost emission cutters reduce their pollution while high-cost emission cutters do not, and face either taxes or having to pay for pollution permits. 

For global pollutants, such as greenhouse gases, there could be international trade in CO₂ permits.  This is the general idea behind “cap and trade.”  For this to work well, however, there would have to be a global monitoring agency that could monitor each source of CO₂  emissions and would be ready to punish those polluters who do so without a permit.  This is the part of “cap and trade” that faces the biggest difficulties.  Remember that real regulation is not done by Soloman-like regulators who are infinitely fair, but by actual people, like international soccer referees, so that various human biases rather than fairness would show through in international environmental regulation.  The problem of political bias and lack of information in regulation is seen in this warning from Pigou himself (Some Aspects of the Welfare State,” Diogenes 7:1-11 (1954), p. 10.):

It must be confessed, however, that we seldom know enough to decide in what fields and to what extent the State, on account of them could usefully interfere with individual freedom of choice. Moreover, even though economist were able to provide a perfect blueprint for beneficial State action, politicians are not philosopher kings and a blueprint might quickly yield place on their desks to the propaganda of competing pressure groups. “Fancy” finance, like a fancy franchise, whatever its theoretical attractions, has, at all events in a democracy, dim practical prospects.

“Cap and Trade,” itself is a good idea.  It is a market-based approach to efficiently reduce the amount of emission of CO₂.  The real difficulties are first, setting the right amount of emissions to allow and second, monitoring and regulating by a global authority, giving up sovereignty to regulators who are likely to want to tilt the playing field away from favoring Americans.  Before going down the road of regulating CO₂ through any approach, we should be very sure of what human reductions in CO₂ will actually accomplish and whether there are alternatives that might work better, such as re-forestation of large areas of the planet.

-MC

Continuing on my oil and gasoline prices theme, I thought I would mention something that is already obvious to many of you, and that is how much gasoline prices have skyrocketed, in spite of the drop of crude oil prices below the $100 mark.  As I write this, on the Sunday evening after Ike hit the Texas coast, gasoline prices in Thibodaux, Louisiana range from $3.79 per gallon at my neighborhood convenience store to $4.68  near downtown Thibodaux.   (For a basic lesson on gasoline pricing, take a look at this primer from the Energy Information Administration of the U.S. Department of Energy.)

Before your knee starts to jerk, and you want to scream “price gougers,” stop for one moment to consider where Ike hit and the industry in that area.  Ike struck Galveston and Houston, but caused flooding all the way to the Mississippi coast. Lake Charles, Louisiana, which was badly damaged by Rita in 2005, was flooded worse by Ike.  The Gulf Coast from Lake Charles, Louisiana to Corpus Christi, Texas, has more than 39 percent of the U.S. capacity for producing gasoline (I found refining capacity information also at the Energy Information Administration site).

With workers to nearly 40 percent of our domestic capacity to refine gasoline unable to get to work, many still in the dark and the sweltering Southern September, with no electricity in their homes and their workplaces likely damaged by the winds and floods, it is perfectly reasonable for the refineries to raise their prices to send the gasoline consumers a clear message: “Conserve! We don’t that have much to go around, and it will have to last until we get these refineries back on their feet.”

Clearly a worse situation would be one where we forced the refineries to keep their prices low, keep them from price gouging, and instead, run out of gas in a week and a half.

Many of us in the aftermath of Gustav, with memories of Katrina still all too fresh, know the feeling of not being able to get gasoline, electricity, fresh water and sometimes even food.  We know that running out of some things, such as gasoline, can sometimes have dire consequences.  I have run out of gas before and probably will sometime in the future.  But if we all run out of gas, our society grinds to a halt.  The food on the grocery store shelves runs out very soon.  Food does not make it from producer to consumer.  We starve.

The large price variation of almost a dollar a gallon from low to high prices should tell us that something else is going on, that is failing to keep prices in their usual close range.  I cannot be sure that this is the reason, but it may have something to do with what we observe:  Many states, and Louisiana is one, have laws that force gasoline retailers to charge a price in accordance to the wholesale price they paid for gasoline.  In Louisiana, before Katrina, gasoline retailers were forced, by law, to charge a 6% markup over wholesale price.  After Katrina, the Louisiana legislature allowed prices to fall to the wholesale price, but no lower.  As explained, wholesale prices went up as Ike wound his way to the beaches and refineries of the Texas oil coast.  Some gasoline retailers still had cheaper gas (as far as the already paid “wholesale price” was concerned), while others had empty tanks and were forced, by law, to charge the new, higher price.

High prices during low production periods send us the same message as a ship captain putting his crew on half rations upon learning that half of his galley supplies became contaminated.  To fail to put a crew on half rations in such a situation would be reckless and irresponsible.  High prices let consumers decide which uses are important enough to pay the high prices and which are not important enough.

You can listen to a brainless, jerking knee and call $4.68 a gallon for regular gasoline “price gouging,” but I call it something else: “social responsibility.”

—-An update:  It seems the fears of the refiners were not borne out and Ike did little damage to our refining capacity as reported by Bloomberg.—-

-MC

In response to the Republican tune (click here to hear the real tune, by Aaron Tippin) of “Drill Here, Drill Now,” Senator and Democratic Presidential Candidate, Burack Obama dismissed the idea of more drilling leading to lower gasoline prices, insisting that we cannot drill ourselves out of high gas prices.  Instead, Obama suggests that we can lower gasoline prices by conserving more, by taking mass transit and by inflating our tires more and by making sure that our vehicles are properly tuned. This call to individual conservation measures will do little that people are not already doing, as people everywhere are driving less, taking mass transit more, riding bikes more, riding their motor cycles more, all out of a sense of individual conservation.

Why are people conserving? Because of the high gas prices. We conserve because of the high prices and we take conserving actions for what we might think of as rather selfish motivation–because gasoline costs too “damned” much, we do it because we cannot afford the high gas prices. And we are also inflating our tires more and getting our cars tuned up more, and we are driving a little slower and a lot less, too.  So, what’s the point?

The point is this. To the extent that people cut consumption of gasoline because of the high gas prices, those conservation actions cannot reduce the price of gasoline. Such conservation actions, as a result of the higher prices, are really the sliding along the downward sloping demand curve that we all know and love. Sliding along the demand curve does not push that demand curve down. It does nothing to shift the demand curve. And unless the demand curve is shifted, the conservation efforts, done because of the high prices will do nothing to reduce those prices. Those conservation efforts, an economist and a mathematician would note, are endogenous.

Now, if tire inflating and tune ups were made mandatory, forced upon everyone, with drivers being pulled over for their engines misfiring or for underinflated tires, there will be little shifting of demand as a result of someone in Washington telling us how to take care of our autos.

So unless the folks in Washington have a plan to force us to take these conservation measures, there will be little effect of this tire inflation campaign, or about as much as Gerald Ford’s WIN buttons (WIN stood for his campaign to “Whip Inflation Now”). Even if we all get our tire gauges out and pump up the tires instead of the volume, we won’t see any kind of price reduction, unless the same amount of pumping up tires occurs at both low and at high gas prices.

By the same token, if we only allow drilling in the OCS or in ANWR because of high oil prices, but we would not do the same thing at lower prices, there will be little effect on prices of such drilling. Neither would there be an effect on oil prices from increased use of alternative fuels (substitutes) if the turn to alternative energy sources is due to the high price of petroleum.

Think of the reasoning a bit more closely. At high gas prices, people inflate their tires to save money, but they don’t do this much at low gas prices because the savings are not as much. Suppose by inflating your tires because of the high gas prices, the demand for gasoline would actually be lower (this, however, is NOT the case). If demand would actually come down, then prices of gasoline would fall, and with the lower gas prices, people would not inflate their tires as much, they would buy more gasoline and the demand for gasoline and the price of gasoline would both go up. And pushing this illogical thought process a bit further, the high price of gasoline would, in turn, pull demand down, with people inflating their tires more, pulling prices down. Around and around she goes, where she stops….

This is exactly how demand and supply analysis is not done. Consumption that changes as a result of the price cannot lead to changes in prices. Production that changes in response to price changes also cannot affect prices. It is only the conservation and production efforts that occur independently of price of the good that can affect that good’s price.

-MC

In this Washington Post article, there is a discussion about how Sen. Obama plans to go after speculators, who he and his advisers see as destabilizing prices the prices of oil.

The only problem with this is that speculators are NOT destabilizing oil prices, and in fact, any intrusion into the futures markets and those where these supposedly evil speculators lurk, will most assuredly destabilize oil prices. We have to be sure about we do before rushing headlong to correct something that may not be broken. Public policy makers should follow the physician’s dictum, “Primum non nocere,” Latin for “first, do no harm,” instead of the politician’s dictum of “do anything, as long as it sounds good, no matter how much harm it might cause.”

First, recall our class discussion on the law of one price. If goods can be moved from one market to another rather costlessly, anytime goods are selling in two different markets at different prices, people will buy them up in the low-priced market and then resell them in the high-priced market. This is called “arbitrage”—buying in one market in order to resell in another. Arbitrage moves goods from lower valued uses to higher valued uses.

People who specialize in market speculation are risking their money on the movement of prices in the future. Essentially, speculators, then, bet on the direction of price movements. Speculators, then, are taking part in a special sort of arbitrage, moving goods from one time period to another. If speculators think that the prices will increase in the future, they buy up such goods now, driving prices up now, and then sell these goods in the future, adding to future supply and reducing prices in the future from what they would be otherwise. If they bet wrong, they lose, they end up buying when prices are higher and then selling the good when the price has fallen, again adding to future supply, but buying at thigh prices and selling at low prices. So, when speculators err, they lose funds and are in less of a position to speculate further.

Those who tend to be good at predicting future prices, then, stay in the market and live to speculate another day. Poor prophets make losses when they buy high and sell low, and so, soon exit the market, as they run out of either their own funds or backers. Poor prophets of future prices do destabilize markets, but they lose money and soon exit the market. Good prophets make profits and stick around the market. Futures markets come to be dominated by good prophets. They buy up in periods of low prices, when goods would otherwise be put to low valued uses (since the market is relatively flooded) and move them to times when they are valued more.

One of the best known stories of speculators is the story of Joseph and Pharaoh. This Joseph is the one from Broadway musical “Joseph and the Technicolor Dreamcoat,” that starred Donny Osmond. This is, of course, based on the story from the Old Testament, where Joseph, a son favored by his father, was the victim of sibling jealousy. As the story goes, his brothers threw him down a well and stained Joseph’s prized “coat of many colors” with pig’s blood in order to deceive their father about Joseph’s fate. Slave traders rescued Joseph from the well and sold him as a slave. He came into the Pharaoh’s employ, became an advisor to the Pharaoh, and ultimately Pharoah’s second in command.

You should recall from this story that Pharaoh began having troubling dreams about seven fat calves followed by seven frail calves and seven full ears of corn (what Europeans called grain and later called maize when they ventured into the New World) followed by seven dried out ears of corn. Pharaoh didn’t understand the meaning of his dream, but Joseph easily figured that in meant that there would be seven years of bountiful harvests followed by seven years of famine, and he shared the meaning with the Pharaoh. Joseph, being a good economist as well as a good prophet, advised the Pharaoh to speculate in the market for grain, buying it up during the years of bounty and storing it during the years of famine, when prices would be much higher. Not only did Joseph and Pharaoh make great sums of profits (from Joseph being a superior prophet), but they also saved lives of people and livestock far and wide. In fact, Joseph’s father, on hearing that Pharaoh had grain to sell, sent his sons to buy grain, where, of course, they found their brother.

Speculators, when they are good prophets, move resources from where they are plentiful to where they are dear. In addition, they stabilize prices, by adding to demand when prices are low, increasing prices, and by adding to supply when prices are high, bringing prices down. Good prophets do good things and make good profits. False prophets do bad things and they make losses for themselves and destabilize prices for others.

We should note that all oil producers are speculators by necessity. Oil producers can extract oil more rapidly or less rapidly. The more they extract from an oil well or from an oil formation now, the less will be available from that formation in the future. If oil producers think that prices will be higher in the future, their opportunity cost of extracting it today is higher and they will extract less oil today. The lower they expect oil prices to be in the future, the lower the cost of extracting that oil today. One result of this logic is that by opening up the Atlantic Coast, the Pacific Coast, the Florida Coast and ANWR to drilling and exploration, the lower prices will be in the future, reducing opportunity costs of extracting oil now and reducing prices immediately upon even hints of discoveries. Another result of this logic is an understanding of why oil companies are not extracting everything that they can now, and why they are preserving oil for the future, unlike what many in Congress want oil companies to do with those oil formations.

The question for Obama’s advisors is “if they are such good prophets and know more about what will happen with the prices of oil than current oil speculators, why is that they are not heavily investing in the futures market for oil, betting that prices will come down and “trading short” (look here in Wikipedia for a good explanation for trading “short”)? Who are the false prophets?

We have to look beyond today’s oil prices, today’s oil demand and today’s oil extraction costs. We need to think about future conditions of the world, especially future conditions in oil producing regions such as the Middle East and especially the Persian Gulf. What are the concerns there?

Well, one concern is our own presence in Afghanistan and Iraq. Is that stabilizing or destabilizing the region? In other words, what effect does our presence there have wars have on the region and on oil prices? What should cause everyone “pause” (the French word for “stop”) is the last remaining part of the Axis of Evil (because North Korea is being so good these days–sure), Iran, and its threats of nuclear devastation of Israel. The greater the threat of confrontation between Israel and Iran, the greater the chance of disruption of oil through the Persian Gulf, the higher the future price of oil and the higher the opportunity cost of extracting oil today.

The high price today guides us learn to conserve oil, guides us to explore more for oil, and guides us to look more for alternative energy sources. In addition, it preserves oil in the ground from being used today to drive one SUV so that it can be used in the future to drive fifteen Mini Coopers the same distance. In other words there really is something worse than high oil prices, and that is prices held artificially low, allowing frivolous current use of oil and then, running out in the future. High prices of depletable resources keep us from running out before we develop more sustainable alternatives.

Some see Obama as soft on Middle Eastern Terrorist and soft on the Iranians, especially when he suggests that he would sit down and talk with the President of Iran. If the likelihood of Obama becoming the next President of the United States is seen as encouraging the Iranians to take action against Israel, then it could even be possible that Obama’s very success could be destabilizing the price of oil. Of course, that is remote, but it is more likely than speculators being wrong about the chance of disastrous Middle Eastern conflict.

-MC