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Friday, September 30, 2005

Economic insanity: A little economic knowledge is a dangerous thing.


A recent editorial in the Washington Post (WP) demonstrates what happens when a little (and I mean very little) economic knowledge is misused to come to an already determined conclusion.

The article claims that taxing the currently high gasoline prices would have a greater impact on fuel conservation than under more normal market conditions. To do this the article uses economics in such an illogical manner that I can’t understand it. As the article states:

“Contrary to what you might suppose, there is something to be said for imposing an energy tax when prices are already high, as they are at the moment. Precisely because consumers are already outraged by fuel prices, a further, tax-induced price increase would force demand down more sharply than it would in normal market circumstances.”

Maybe the author this editorial missed that day in basic economics (that is if the author actually took economics) when they covered the fact that price (which covers tax) is implicit in the model of demand. That is a change in price will change the quantity demanded and not the entire demand curve. As fore the claim that taxing an already increase price would reduce quantity demanded more would require a demand curve to become more elastic as the price increases. That means the demand curve would have to be shaped concave to the origin. That I’ve never seen.

Maybe though it was a momentary lapse; I’m sure we all have had those moments when we just get our facts wrong. That may be true of other cases of misapplication but the errors just keep coming in this article. For example take this little gem of economic analysis:

“Consumers don't like cutting back. But the sharp reduction in demand would cause the pretax fuel price to fall sharply, too, offsetting the after-tax increase.

This is a smart way to make oil producers subsidize U.S. taxpayers. Because of the energy tax, producers would face lower demand and lower market prices; they would, in effect, pay perhaps a quarter of the energy tax, with consumers picking up the balance.”

Before I try to tackle the issue of subsidy; there is evidence in this quote that the author of this article is not as ignorant about economics as one might believe. That is to say there is a grain of truth (although be it very small) about who pays the tax.

As I am sure the reader is aware it is the supply that shifts (vertically upward by the amount of the tax) and the only effect in demand is most likely a change in quantity demanded. I say most likely because the slope of the demand curve would need to be known to determine the exact share the supplier and buyer pay. If for some reason demand was perfectly inelastic a tax placed on the product would not change the quantity demanded and the price would increase by the full size of the tax. For demand curves that aren’t perfectly inelastic the curve is less than vertical and so the price does not shift up by the entire size of the tax. That difference is paid for by the supplier. That grain of truth though was severely distorted in the editorial.

The distortion comes in the discussion of the pretax fuel price. I honestly cannot be sure what the author meant by pretax fuel price. The price paid before the tax was enacted will not change as a result of the tax. It was what it was no matter how much it is altered now. What I think was meant is that the price the oil company receives from the sale of fuel is lower now as a result of the tax, but this in no way can be said to be a pretax price because this lower price is a direct result of the tax. Therefore it is the elastic nature of the downward sloping demand curve that, when faced with a per unit increase of the good, results in a lower quantity demanded, which in turn causes the price to rise by less than the full amount.

Now I shall turn back to the issue of the subsidy. If we are to be accurate about a subsidy it would be a vertical shift up in the demand curve by the size of a subsidy. So, if anything, a subsidy would increase the price oil company receives for any quantity demanded. This is exactly opposite to what is said in the editorial. Thus a tax is not a subsidy to the fuel market. The only truth about the tax is that it is not entirely born by the consumer. This is only a critique of the use of economics tools, and there is plenty to be said about the application of economics from a normative framework of liberty and efficiency.

From the standpoint of economic efficiency it’s clear that their needs to be a source of market failure for justification of governmental interferences. The article does not talk about monopolist power being used; I can’t see how public good can be applied to gasoline as a good; so maybe the market inefficiency is through an externality. While pollution from fuel burning can be considered an externality; pollution is not mentioned in the article. The only defense made for the tax is that of conservation, but what externality exists if consumers use oil now instead of preserving the supply for later use?

From economic liberty this author’s tax is clearly an affront to liberty as demonstrated by this passage:

“It [President Bush’s statement urging conservation of fuel] recognizes that any serious energy strategy has to include conservation. But there is a difference between supplication and policy. If Mr. Bush really wants to promote more careful energy consumption, he ought to tax it.”

In other words if something should be done, people should be coerced into providing it. The author of the editorial tries to disguise the coercion as a promotion, but promotion would be to persuade people of the importance energy conservation and not to force its importance upon the people. Careful energy consumption is not something people in general are willing to provide, but for some reason it is argued that the U.S. government’s power (given to the government by those same people) should be used to provide it. If the people don’t want energy conservation government’s use of coercive power to provide it is against economic liberty.


Comments:
regarding polution reduction, at least in terms of smog an toxic polution, a few older vehicles create far more than newer vehicles. Yet many states tax vehicles based on value. This discourages replacement of polluters with cleaner vehicles.

Would a gasoline tax provide other market distortions by depriving energy companies of the full value of what they sell?

We already have an effort to promote ethanol, which is to some extent a fancy way to turn diesel into alcohol since it takes almost as much energy to make it as we get from it.

Does that make sense?
 
Speaking of coercive government "savings" programs

"“LIHEAP is an important program that helps low income households meet the high seasonal cost of heating their homes,” the Governor said. “The pressures on the program this year are twofold: We have seen a dramatic increase in the price of fuel and we are also seeing increased demand.”

Douglas instructed his staff earlier this year to find a way to offer LIHEAP recipients the same amount of purchasing power as last year when the average benefit was $902, or approximately 440 gallons of fuel. "

http://www.vermont.gov/tools/whatsnew2/index.php?topic=GovPressReleases&id=1517&v=Article
 
Ethanol fuel is supposed to be a new alternative which in the long-run will become viable, but as it stands now there gains a small. The only way we would ever find out if it could produce fuel is to try. At this stage I still believe ethanol can has viability, and so I think it does make sense for now.

Taxes are not inherently evil; they just seem to end up being used that way. A gasoline tax, in theory devoid of politics, is not a question about companies capturing the full value of their product. It is a question of the companies not incurring the full cost of their product. The byproduct of using the fuel is pollution, but neither the buyer or seller face this cost in their decision making. That is, pollution is a cost as a result of the market of fuel but the market does not face this cost. For efficiency this cost needs to be internalized into the market; one such tool is taxation. There are some problems with this simple scenario. For one, taxes are controlled by politicians who do not always make decisions based upon economic efficiency. The phrase, ‘efficiency is nice, but will it get me votes’ keeps coming to mind.

Speaking about pollution and older vehicles you did make one observation I agree with. Basing a tax upon the value vehicles creates an incentive to vehicle owners to retain their older vehicles longer that they otherwise would.

In all, gasoline is a market that isn’t quite perfect; some might say it’s quite far from perfect. Perfect or not, as long as it remains the backbone of the modern economy it will be a market of much discussion.
 
While I lack the technical training to justify it, I find the idea of a fuel tax to pay for roads to very reasonable. Since fuel consumption has a close relationship with the wear and tear a vehicle causes on the road (both due to weight and time in motion. I would have no objection to an increase in fuel tax to fund improved road maintenance in preference to general fund taxation. Roads and vehciles are intertwined and each brings value to the other.

A gasoline tax just to raise the price lacks proportionality. Pollution is more a function of how the fuel is used (clean engines vs dirty engines). If we really want to tax pollution, let's measure emissions and charge more for dirty engines.

Seems to me that the way to find out if ethanol is viable, is to let investors take their best shot. Government incentives and "investments" generally have a very poor return. The best incentive possible would be to allow investors to keep the money they make and minimize silly regulations.

I like taxes and fees that bear some relation to the value delivered. For example, Hunting licenses paying for game management, vehicle registration might pay for some road maintenance, traffic enforcement and some emergency services.

Warning: sharp tangent ahead:

Why do we now have such a shortage of refinery (or other energy infrastructure) capacity? Could it be that the return does not justify the risk? If we want to encourage spare capacity, then I think we must cut the risk, or at least the artificial risk due to unpredictable liablility or regulation.

If a farmer stands to lose his farm because his tractor runs over a Prebbles Jumping Mouse (which turns out to be an invented species), it might make farming seem less attractive. If a medical appliance maker stands to lose their business to unsubstantiated allegations of harm that could not be known in advance, then why bother? (see Dow Corning breast implant bankruptcy). If a trash hauler can be forced to pay to cleanup a superfund site because he purchased a dumpster that was once used to haul waste there, why not demand a large risk premium?

Return to one of your points:

I will accept that materials that are toxic and not normally in the environment are almost unconditionally pollutants (Nox, CO, sulfates, excessive superfine particulates, heavy metals) but I still have trouble with equating all emissions at pollution. CO2, for example, is as much a fertilizer as a pollutant. There are few complaints about water (in fact the Army is looking to harvest water from exhaust for drinking) It is also hard to avoid emissions. The alternatives all seem to be prohibited anyway (hydro (kills salmon), wind (kills birds, ugly), nuclear (if it is new is must be bad).
 
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