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Saturday, September 30, 2006

Arnold Made me an Offer I Couldn't Refuse

I have recently stumbled across an interesting article “Global Warming Initiative signed” in the Washington Times, published September 28, 2006. These are the key lines depicting the essence preceding this policy’s analysis listed below:

Gov. Arnold Schwarzenegger yesterday signed into law a sweeping global warming initiative that imposes the nation's first cap on greenhouse gas emissions, saying the effort begins. It imposes a first-in-the-nation emissions cap on utilities, refineries and manufacturing plants in a bid to curb the gases that scientists blame for warming the Earth.

California's efforts to cut greenhouse gas emissions from industry and automobiles are part of a goal to reduce the state's emissions to 1990 levels by 2020, an estimated 25 percent reduction.

I. My first question concerns the motives and reasons for the intervention of government into the private industry and the mandatory implementation of cleaner technologies. Shortly, can efficiency be achieved by private sector without government intervention?

I say no. I do so due to the presence of external marginal cost that is not captured by anyone in the markets for utilities, refineries, and particular segments of manufacturing industry. In other words, I suggest this is the classical case of negative externality. I assume this because businesses lack incentives to innovate and/or voluntarily install cleaner technologies as the latter do not result into marginal revenues. As a result, it is cheaper to simply blow the byproducts of production out of stack. Given such status quo, I accept there might be a role for the government to play.

II. Either way, one should perhaps refer to a perfectly competitive market model to understand the micro implications of such a proposal. Setting a standard for the abovelisted industries would inevetably force them to incur significantly higher costs and upgrade their equipment. Those added costs would therefore result in the upward shift of the supply curve for every business under consideration. The outcome would be a decreased quantity demanded and a higher equilibrium price in the market. My question is- who will bear the cost of the newly installed equipment?
It is not the business but the consumers of those goods and services who will bear the costs. I bluntly state that every such firm under consideration would implement a “compensating differential.” The total cost incurred would be divided by the number of buyers and added to the current cost of a good the business offers in the market.

III. All the issues under consideration are taking place in California. Here is a part that makes me wonder. Is there anyone in the U.S or even in the world, who is not paying for products and services that are rendered by the Californian utilities, refineries, and manufactiring plants and still deriving the benefits?
In other words, would such policy have a potential for generating positive externalities?

I say YES! If some people buy cement, oil and some refined oil products, and others from California are getting their electricity locally and yet…because of the higher standards implemented on the “left coast” I, a UCCS student, am not getting rained on by an acid rain in Colorado, which would have been a result of Californian production had the standards not been implemented- I am better off. I derive the benefits that others pay for, and I derive them free of charge! I portray a strong free rider behavior and I love it!

Whether you agree with me or not, the positive externality model establishes grounds for action. I will briefly mention that there is room for potential Pareto improvement as the benefits associated with such an initiative would neither be equal to nor be less than costs (which leaves only one possible outcome).

My final word in analyzing the State of California’s newly enacted law is positive one: I approve of such action.

The market economic activity that many think contributes to global warming does fit the model of a negative externality. This model suggests an efficient policy response is some policy that causes the marginal external cost to be internalized.

Your comment with respect to this government policy is really pointing out that we can use the model of a public good in this case to characterize the nature of government action to reduce the threat of global warming. And, this is often the case. Many pollution externalities have external costs that tend to be characterized by nonrivalry and nonexcludability.

You also discuss who will pay the additional costs associated with regulation and you suggest it will be the consumer. When we discuss the topic of tax incidence you will learn that in general both consumer and producer (and perhaps if input owners) will share in the incidence (or payment) of the tax. The same is to be expected with the increased costs to polluters due to government regulation.

You say you approve of the policy because you like to free ride. Fair enough. But, I wonder what the people of California should think about the policy? My assumption is that California makes a relatively small contribution to the global warming concern on its own. The policy may be expected to result in significant cost to the residents of California, but probably for very little real benefit. In contrast to the Governor's expectation that many others in the world will follow the leader, I wonder if we should expect free rider behavior from the "followers?" And I wonder if it is irrational for California government to not free ride?
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