Naked Economics (10 page)

Taxing a behavior that generates a negative externality creates a lot of good incentives. First, it limits the behavior. If the cost of driving a Ford Explorer goes to 75 cents a mile, then there will be fewer Explorers on the road. As important, those people who are still driving them—and paying the full social freight—will be those who value driving an SUV the most, perhaps because they actually haul things or drive off-road. Second, a gas-guzzler tax raises revenue, which a ban on certain kinds of vehicles does not. That revenue might be used to pay for some of the costs of global warming (such as research into alternative energy sources, or at least building a dike around some of those Pacific island nations). Or it might be used to reduce some other tax, such as the income or payroll tax, that discourages behavior we would rather encourage.

Third, a tax that falls most heavily on hulking, fuel-hungry vehicles will encourage Detroit to build more fuel-efficient cars, albeit with a carrot rather than a stick. If Washington arbitrarily bans vehicles that get less than eighteen miles per gallon without raising the cost of driving those vehicles, then Detroit will produce a lot of vehicles that get—no big surprise here—about eighteen miles a gallon. Not twenty, not twenty-eight, not sixty using new solar technology. On the other hand, if consumers are going to be stuck with a tax based on fuel consumption and/or the mass of the vehicle, then they will have very different preferences when they step into the showroom. The automakers will respond quickly, and other products like the Hummer will be sent where they belong, to some kind of museum for mutant industrial products.

Is taxing externalities a perfect solution? No, far from it. The auto example alone has a number of problems, the most obvious of which is getting the size of the tax right. Scientists are not yet in complete agreement on how quickly global warming is happening, let alone what the costs might be, or, many steps beyond that, what the real cost of driving a Hummer for a mile might be. Is the right tax $0.75, $2.21, $3.07? You will never get a group of scientists to agree on that, let alone the Congress of the United States. There is an equity problem, too. I have stipulated correctly that if we raise the cost of driving gas guzzlers, then those who value them most will continue to drive them. But our measure of how much we value something is how much we are willing to pay for it—and the rich can always pay more for something than everyone else. If the cost of driving an Explorer goes to $9 a gallon, then the people driving them might be hauling wine and cheese to beach parties on Nantucket while a contractor in Chicago who needs a pickup truck to haul lumber and bricks can no longer afford it. Who really “values” their vehicle more? (Clever politicians might get around the equity issue by using a tax on gas guzzlers to offset a tax that falls most heavily on the middle class, such as the payroll tax, in which case our Chicago contractor would pay more for his truck but less to the IRS.) And last, the process of finding and taxing externalities can get out of control. Every activity generates an externality at some level. Any thoughtful policy analyst knows that some individuals who wear spandex in public should be taxed, if not jailed. I live in Chicago, where hordes of pasty people, having spent the winter indoors on the couch, flock outside in skimpy clothing on the first day in which the temperature rises above fifty degrees. This can be a scary experience for those forced to witness it and is certainly something that young children should never have to experience. Still, a tax on spandex is probably not practical.

I’ve wandered from my original, more important point. Anyone who tells you that markets left to their own devices will always lead to socially beneficial outcomes is talking utter nonsense. Markets alone fail to make us better off when there is a large gap between the private cost of some activity and the social cost. Reasonable people can and should debate what the appropriate remedy might be. Often it will involve government.

Of course, sometimes it may not. The parties involved in an externality have an incentive to come to a private agreement on their own. This was the insight of Ronald Coase, a University of Chicago economist who won the Nobel Prize in 1991. If the circumstances are right, one party to an externality can pay the other party to change their behavior. When my neighbor Stuart started playing his bongos, I could have paid him to stop, or to take up a less annoying instrument. If my disutility from his noise is greater than his utility from playing, I could theoretically write him a check to put the bongos away and leave us both better off. Some contrived numbers will actually help to make the point. If Stuart gets $50 of utility from banging away, and I feel the noise does $100 an hour of damage to my psyche, then we’re both better off if I write him a check for $75 to take up knitting. He gets cash that does him more good than the bongos; I pay for silence, which is worth more to me than the $75 it costs.

But wait a minute: If Stuart is the guy making the noise, why should I have to pay him to stop? Maybe I don’t. One of Coase’s key insights is that private parties can only resolve an externality on their own if the relevant property rights are clearly defined—meaning that we know which party has the right to do what. (As we’ll explore later in the chapter, property rights often involve things far more complicated than just property.) Does Stuart have the right to make whatever noise he wants? Or do I have the right to work in relative quiet? Presumably the statutes for the city of Chicago answer that question. (The answer may depend on time of day, giving him the right to make noise up until some specified hour and giving me the right to silence during the nighttime hours.)

If I have the right to work in peace, then any payment would have to go the opposite direction. Stuart would have to pay me to start banging away. But he wouldn’t do that in this case, because it’s not worth it to him. As a temperamental writer, the silence is worth $100 to me, so Stuart would have to pay me at least that much to endure the noise. Playing the bongos is only worth $50 to him. He’s not going to write a check for $100 to do something that provides only $50 of utility. So I get my silence for free.

This explains Coase’s second important insight: The private parties will always come to the same efficient solution (the one that makes the best use of the resources involved) regardless of which party starts out with the property right. The only difference is who ends up paying whom. In this case, the disputed resource is our common wall and the sound waves that move back and forth across it. The most efficient use of that resource is to keep it quiet, since I value my peaceful writing more than Stuart values his bongo playing. If Stuart has the right to make noise, I’ll pay him to stop—and I get to write in peace. If I have the right to silence, Stuart won’t be willing to pay enough for me to accede to his bongos—and I get to write in peace.

Remarkably, this kind of thing actually happens in real life. My favorite example is the Ohio power company that neighbors claimed was emitting “a bizarre blue plume” that was causing damage to property and health. The Clean Air Act gave the town’s 221 residents the right to sue the utility to stop the pollution. So the American Electric Power company had a decision to make: (1) Stop polluting; or (2) pay the entire town to move somewhere else.
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The
New York Times
reported on the answer: “Utility Buys Town It Choked, Lock, Stock and Blue Plume.” The company paid the residents roughly three times what their houses were worth in exchange for a signed agreement never to sue for pollution-related damages. For $20 million, the utility’s problems packed up and went away—literally. Presumably this made financial sense. The
New York Times
reported that this settlement was believed to be the first deal by a company to dissolve an entire town. “It will help the company avoid the considerable expense and public-relations mess of individual lawsuits, legal and environmental experts said.”

Coase made one final point: The transactions costs related to striking this kind of deal—everything from the time it takes to find everyone involved to the legal costs of making an agreement—must be reasonably low for the private parties to work out an externality on their own. Stuart and I can haggle over the fence in the backyard. The American Electric Power company can manage to strike a deal with 221 homeowners. But private parties are not going to work out a challenge like CO
₂
emissions on their own. Every time I get into my car and turn on the engine, I make all of the six billion inhabitants of the planet slightly worse off. It takes a long time to write checks to six billion people, particularly when you are already late for work. (And it’s arguable that some people in cold climates will benefit from climate change, so maybe they should pay me.) The property rights related to greenhouse gases are still ambiguous, too. Do I have the right to emit unlimited CO
₂
? Or does someone living in a Pacific island nation have the right to stop me from doing something that might submerge their entire country? This is one conflict that governments have to tackle.

But let’s back up for a moment. Government does not just fix the rough edges of capitalism; it makes markets possible in the first place. You will get a lot of approving nods at a cocktail party by asserting that if government would simply get out of the way, then markets would deliver prosperity around the globe. Indeed, entire political campaigns are built around this issue. Anyone who has ever waited in line at the Department of Motor Vehicles, applied for a building permit, or tried to pay the nanny tax would agree. There is just one problem with that cocktail party sentiment: It’s wrong. Good government makes a market economy possible. Period. And bad government, or no government, dashes capitalism against the rocks, which is one reason that billions of people live in dire poverty around the globe.

To begin with, government sets the rules. Countries without functioning governments are not oases of free market prosperity. They are places in which it is expensive and difficult to conduct even the simplest business. Nigeria has one of the world’s largest reserves of oil and natural gas, yet firms trying to do business there face a problem known locally as BYOI—bring your own infrastructure.
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Angola is rich with oil and diamonds, but the wealth has financed more than a decade of civil war, not economic prosperity. In 1999, Angola’s rulers spent $900 million in oil revenues to purchase weapons. Never mind that one child in three dies before the age of five and life expectancy is a shocking forty-two years.
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These are not countries in which the market economy has failed; they are countries in which the government has failed to develop and sustain the institutions necessary to support a market economy. A report issued by the United Nations Development Program placed much of the blame for world poverty on bad government. Without good governance, reliance on trickle-down economic development and a host of other strategies will not work, the report concluded.
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The reality is that nobody ever likes the umpire, but you can’t play the World Series without one. So what are the rules for a functional market economy? First, the government defines and protects property rights. You own things: your home, your car, your dog, your golf clubs. Within reasonable limits, you can do with that property as you wish. You can sell it, or rent it, or pledge it as collateral. Most important, you can make investments in your property having full confidence that the returns from that investment will also belong to you. Imagine a world in which you spend all summer tending to your corn crop and then your neighbor drives by in his combine, waves cheerily, and proceeds to harvest the whole crop for himself. Does that sound contrived? Not if you’re a musician—because that is pretty much what Napster did by allowing individuals to download music without paying any compensation to the musicians who created it or to the record companies that owned the copyrights. The music industry successfully sued Napster for facilitating piracy.

Property rights are not just about houses, cars, and things you can stack in a closet. Some of the most important property rights involve ownership of ideas, artwork, formulas, inventions, and even surgical procedures. This book is as good an example as any. I write the text. My agent sells it to a publisher, who contracts to have the book printed and distributed. The book is sold in private stores, where private security guards are hired to handle the massive, potentially unruly crowds trying to get a signed copy. At every juncture, only private parties are involved. These would appear to be straightforward market transactions; government could only get in the way. Indeed, I might curse the government for taxing my income, taxing the sale of the book, even taxing the salary that I pay the nanny to look after my children while I write.

In fact, the whole transaction is made possible by one thing: copyright law, which is a crucial form of property right for those of us who write for a living. The United States government guarantees that after I invest my time in producing a manuscript, no company can steal the text and publish it without compensating me. Any professor who photocopies it to use it in a class must pay the publisher a royalty first. Indeed, the government enforces similar rights for Microsoft software, and a related property right, a patent, for the pharmaceutical company that invented Viagra. The case of patents is an interesting one that is often mischaracterized. The ingredients in Viagra cost pennies a pill, but because Pfizer has a patent on Viagra that gives it a monopoly on the right to sell the product for twenty years, the company sells each pill for as much as $7. This huge markup, which is also common with new HIV/AIDS drugs and other lifesaving products, is often described as some kind of social injustice perpetrated by rapacious companies—the “big drug companies” that are periodically demonized during presidential campaigns. What would happen if other companies were allowed to sell Viagra, or if Pfizer were forced to sell the drug more cheaply? The price would fall to the point where it was much closer to the cost of production. Indeed, when a drug comes off patent—the point at which generic substitutes become legal—the price usually falls by 80 or 90 percent.