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Climate Economics 101 or Why We Do what We Do

by James Barrett • July 12, 2010 @ 9:03 am

When I introduce myself as an economist, one of the most common reactions I get from people is “No offense, but I hated economics in college.” I understand. I’ve both taken and taught economics at the college level, so I am both victim and perpetrator of our particular crime. The problem, as I try to explain to people, is not that economics is particularly difficult, but that it is often counter-intuitive. A lot of fundamental economics runs counter to common sense or, at the very least, does a good job of hiding from it.

Oddly, climate economics does not fall into this category. On one hand it is actually pretty complicated in places, but the other hand, there is a lot of common sense involved. The fundamental axiom of climate economics is, loosely translated, “You break it, you buy it.”

A lot of economic activities create unintended side effects. Pollution is one of those side effects. If you need to go to the hospital for whatever reason, the car or ambulance you ride in creates pollution, which is a bad thing. It’s not enough to make us not want people to go to the hospital, but if we could manage to get people well without the pollution (or at least with less), we’d prefer it.

Going to the hospital involves a lot of costs and market transactions. The ambulance, paramedics, doctors and nurses must all be paid for. In each case someone is accepting payment in return for goods or services delivered. From an economic standpoint, this is a good thing. No one is being forced to work, and if people don’t like the price they are being offered, they are free to turn it down and look for something better. At each point along the chain of transactions, every participant feels as though he or she is better off as a result.

The same can not be said for the energy used in the process. The gas station sold the gas to the ambulance company, and the ambulance company bought it under the assumption that could recover the costs when they bill for their services. There is at least one transaction going on in which people are giving up something of value without their consent and without getting compensated. This is the pollution created by burning gasoline. When people go to the hospital or the store or anywhere else, they turn some of our clean air into somewhat less clean air, which, after enough people do it, imposes significant costs on everyone, a cost which they did not have to pay at any point along the chain of transactions they set in motion.

From an economic standpoint, the problem is that the people who create the pollution (in this case, the person going to the hospital) pays none (or at least very little) of the cost of the pollution they create. In the larger scheme of things, the amount of pollution created is pretty small, and the costs it creates, in terms of acid rain, smog, asthma, or climate change, is also pretty small. But all the trips to the doctor and everywhere else the everyone goes can add up, and the costs of the pollution they create adds up as well.

So here’s where economics comes in. When we drive our cars (turn on our electricity, heat our homes, or buy anything that took energy to make), we get a free ride. We create a cost that someone else is going to have to pay. Economists look at this situation and typically respond with atypical common sense: people should pay the full costs that their behavior creates.

This is the “tragedy of the commons.” If you give people access to something for free, inevitably, more people want to use more of it. As long as people and businesses don’t have to pay for the pollution they create, why should they expend money and effort to avoid polluting? In some cases people will try to cut down on pollution because it’s important to them for personal reasons, but for the most part, they don’t, and we end up with things like acid rain, rivers on fire,  and climate change.

The economists’ solution to this problem is to first figure out what that cost is and then find a way to make that cost included in the market transaction that creates it.

In this example, the simplest ways to do this would be to attach a pollution tax to the gasoline. If burning a gallon of gas creates ten cents’ worth of pollution costs, then we should add a pollution tax of ten cents to each gallon of gasoline.

Things get a little less common sense-y at this point, because economists will also tell you that it’s not necessary to find the people who have to bear the cost of the pollution and give them their share of the tax (though it might be a nice thing to do). Nor do we even have to spend the ten cents on cleaning up the pollution. The point is that we’re trying to get people to use the exact optimal amount of gasoline. We know it’s not zero because we want people to go to the hospital when we need a doctor or to the store when they need to buy things. But we also know that people use too much, because the true total cost of a gallon of gasoline (the price of gasoline plus the costs of the pollution it creates) outweighs the price of gasoline (how much we pay for at the pump).

The economists’ response to climate change is roughly the same: figure out the costs created by each ton of climate pollution, and make emitters pay that amount. It doesn’t matter who they pay it to, as long as they face the full cost of their behavior, their consumption patterns will fall in line with economic optimum.

This is the ideal we are after. Unfortunately, getting there can be hard. Figuring out such things as the cost that one ton of carbon pollution creates so we can charge that price is difficult. Finding a mechanism to charge that price is less tricky conceptually, but can be difficult to implement both politically and practically. And the whole thing depends on markets delivering the right price signal to the right points in the economic system. All of these issues (and more) are where climate economics and climate policy can get very complicated, and are something we’ll talk more about in the coming weeks on this blog.

By James Barrett, Chief Economist, Clean Economy Development Center

1 Comment

  1. [...] Putting a price on carbon is a second key element of smart climate policy. An underlying reason for our current situation is that we have treated the Earth’s limited capacity to absorb and recycle carbon emissions as if it was infinite. When useful things are in infinite supply, they’re free. When useful things are scarce, they have a price. To send the proper market signals to consumers and producers, we need to correct this mistake by putting a price on carbon emissions. [...]

    Pingback by Essentials of Smart Climate Policy « Real Climate Economics — July 19, 2010 @ 11:16 am

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