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Monday, May 14, 2007

Scattered Thoughts about Markets

It is customary for economists to presume that technological innovation is a process exogenous to economic activity. So, the economic forces are helpless in the process of new capital formation, in spite of the grandiose desire of the entrepreneurs. Instead, it is some ingenious scientist that announces his innovation (like a laser), which later gets incorporated into the manufacturing of cool-looking gadgets and gizmos (entrepreneurs are happy again).

One might be tempted to speculate that innovation is a pure function of its funding. However, a stubborn attempt to inject money into seemingly dead projects has historically proven to be an ineffective technique. It is so because technological innovation emerges in the minds of scientists, which is a non-linear and dynamic process. Conclusion: the almighty market itself is helpless when it comes to innovation.

Unlike the technological innovation, a market for existing technologies (like electricity generation) stubbornly tries to persuade us that it will take care of things on its own. It begs us not to call the government, unless it is in trouble, unless the market fails.

We, economists, recognize there might be a role for government to play in cases of a monopoly, a public good, or an externality. Few months ago, if asked whether acid rain truly represents a negative externality, I would have expressed an undisputable “yes.” However, it seems to me now, the theory of negative externality is not that certain in the case of acid rain. In my previous post “Acid Rain- a Silent Agitator” I have described the process of this external cost being captured by the market. My question is: if acid rain is really not a negative externality, could there still be a legitimate role for the government to play?

Here is the way I see it. A producer creates pollution in the process of generating electricity. That pollution is not internalized in the prices, and is therefore external to the transaction. It is, however, captured by a different market, one for property insurance. Hence, no negative externality exists. At this point an economist would typically express an opinion to refrain from government intervention and not to implement a corrective tax. But isn’t there something inevitably wrong with this picture? Despite the fact that the home insurance market is internalizing the damage, property owners sustained genuine damage that is objectively measurable. Do they not deserve the compensation? Just like in the case of technological innovation described above, the almighty market is helpless on the grounds of efficiency. The Gods have spoken.

Another issue would involve determining which one of the thousands of manufacturing plants has released the chemicals into the atmosphere and is ultimately responsible for the property damage of the homeowners. If that question does not seem tricky enough, try measuring harm accrued to individuals’ health that was caused by pollution. Or was it? Maybe they just had a genetic predisposition to lung cancer and just happened to live nearby a coal-fired plant? We might never know.

Now assume I am very wrong on this and wrong in my previous post to this blog. You suspected acid rain was an externality and you were right all along. When the government taxes the manufacturing plants, trying to remove that marginal external cost, where does the money go? Does it go to compensate the “victims” of pollution? If there aren’t any, does the government pay a third-party contractor to install the filters inside the smoke stacks so that such high concentration of chemicals is never released into the air again? Or does the government keep the money, appropriating it to whatever means it desires (ha!), yet mandating the manufacturer still installs the filters? I think the latter is true. If caught, a producer is mandated to pay a fine (once again, I’m not sure where the money goes) and then to install the filters.

So where do those funds go? Where can they be spent/invested? Could those funds subsidize or even fully finance building a new nuclear reactor? Larry Eubanks only knows. But if such monetary expenditure of funds is considered appropriate, it would be attributable to market failure in a slightly different meaning of a term. Private market would be quite hesitant to forgo such sizable investment due to the following reasons:
1) Enormous initial investment coupled with minuscule profit margins. It is thus highly unlikely an entrepreneur will recover initial investment and/or be profitable.
2) Inability to price discriminate.

That is precisely why a newly created nuclear reactor would be government-owned. Does anyone know if those things can be leased to qualified private businesses, under close supervision of the Big Brother of course, or would it be the “national defense- strategic resource” argument to justify the government maintaining it? More on nuclear power industry in my next post.

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