The House of Representatives just passed (barely!) the climate change bill, although analysts say that it will face a tough road in the Senate. This is the bill that includes a cap and trade system for carbon, or “cap and tax,” as the Republicans call it. Certainly the Republicans, and all the conservative bloggers, have attacked the bill, saying that it will increase the cost of energy and of many manufactured goods, and those increased costs will be passed on to consumers. And I agree; costs will go up, which is exactly the point. The cost of things that create carbon should go up. To explain this, I thought it might make sense to take a step back and discuss externalities.
In economics, “an externality…of an economic transaction is an impact on a party that is not directly involved in the transaction.” There can be positive and negative externalities, but the classic example is a negative one: pollution. If a plant manufacturing widgets spews its waste chemicals into a river, poisoning that river for 15 miles downstream, that is an externality. People downstream – fishermen, swimmers, kayak tour guides – suffer an impact from the widget manufacturing, but they have no economic say in that impact.
You might just say “whatevs,” as many have said over the years about pollution, but even the most ardent free market fan should recognize that externalities warp the market. As the supply-demand graph (a diagram dear to the heart of any good capitalist, and to me, since I was an econ major) below shows, an externality causes the market to produce too much of a good, at too low of a price, relative to the optimal solution if the externality is taken into account. This is not efficient, and economists hate inefficiency.
Of course, as regular readers of Thoughtbasket know, I am not an ardent free market fan, so I would layer in an ethical cost as well. Why should the owners of the widget plan make money at the cost of the health of people living downriver? Who gives them the right to take the public good – the river – and ruin it?
Fortunately, both the economic and the ethical problem can be solved by actually monetizing the externality and including it in the business calculation. Polluting a common good should not be free. Assign an actual cost to polluting, and charge the factory owner that cost, and you will quickly see the plant move to producing the preferred social equilibrium quantity. Of course it is tremendously difficult to come up with the appropriate cost, but it’s difficult to go to the moon too, and we still managed that (unless you are a conspiracy theorist). Just because something is hard doesn’t mean we shouldn’t do it.
Unfortunately for factories, as science discovers more pollutants that are bad for us, there are more and more externalities that they have to take into account. Carbon and global warming are a perfect example. Carbon emissions didn’t reach the externality level – unlike, say, dioxin spewing into a lake – until science discovered that global warming was going to kill us all.
Hence, cap and trade legislation. Which is, in many ways, as the Republicans have pointed out, like a carbon tax. Either way, the point is to take what was a social cost – the spewing of carbon – and then monetize it and apply it to producers. What will happen as the costs of carbon go up? We will use less of it. Factories will figure out how to make their widgets using less carbon. People will turn their air conditioners down. Whatevs. Make carbon expensive and people will use less of it, moving production down to the appropriate social equilibrium. That’s what the economists would want, and it’s certainly what our grandkids will want.