Crawl Across the Ocean

Thursday, February 21, 2008

Because People on The Internet Are Wrong

(source for the post title is here)

In view of recent events, I think it might be wise to have a little refresher on the basics of microeconomics - don't worry, I am going to keep it simple:

Microeconomics is the study of two things: supply and demand. To keep it simple, I'm only going to talk about demand in this post. With the odd exception, Microeconomics says two things about demand:
1) If the price of something goes up, demand goes down. i.e. People buy less of something when it is more expensive.
2) If the price of something goes down, demand goes up. i.e. People buy more of something when it is less expensive.

Retail stores take advantage of this microeconomic theory when they do things like 'holding sales' in which they lower prices in the expectation that demand will rise.

The classic microeconomic demand curve thus looks something like this*:




You can see that as price goes up (as you move to the right on the chart) demand goes down (the line slopes downward). On the flip side, as price goes down (you move to the left on the chart), demand goes up (the line slopes up to the left).

To make it more concrete, imagine that the line represents sales of big screen TV's. You can imagine, that if the price of a 42 inch LCD TV dropped from $3,000 to $2,000, people would buy more.

Let's make it even more concrete by considering one single person, let's call him Bob, who has the following willingness to buy a 42 in ch LCD TV at various prices.

Price > $1,000 - Bob won't buy
Price between $500 and $1,000, Bob will buy 1 TV
Price less than $500, Bob will buy 2 TV's.

So the demand chart for Bob looks like the following:



You can't see the line past $1,000 because it's at 0 (since Bob buys 0 TV's at that price.

Now, let's imagine a scenario where the government decided the key to the provinces future is that people buy more TV's. Perhaps they've seen the studies that show that people who watch TV spend more and save less and they figure this will boost retail sales, but the motive doesn't really matter. So we'll say that the current price of a 42 inch TV in this example is $2,000 and the government introduces a $200 subsidy so that the price for the consumer drops to $1,800.

Bob might have one of two possible reactions to this news:

1) Well, $1,800 is still too expensive for me so it won't change my behaviour, but I bet that in a province with millions of people, there are some out there who are willing to buy at $1,800 but not at $2,000.

OR

2) Well, $1,800 is still too expensive for me so it won't change my behaviour. So I'd bet this subsidy is too small to have any impact on TV sales.

If Bob's reaction #1 is correct, then the demand curve would like the following:



In this world, any change in price, even a very small one, leads some people to change their behaviour, because there are so many people that there are bound to be some where that price change was their personal tipping point.

If Bob's reaction #2 is correct, then the demand curve would look like the following.



Nobody in the province will buy a TV until the price drops from $1001 to $1000, and then everybody in the province buys a TV all at once.

In my opinion, and in the opinion of every microeconomist in the world, scenario #1 is the correct one.

Which brings us to the carbon tax introduced in the B.C. budget. Here, instead of reducing the price of TV's in order to increase demand, the government is increasing the price of carbon emissions in order to reduce demand.

Again there are 2 possible reactions:

1) This small increase is likely to change the behavior of those people who were near the tipping point for changing their behavior already.

OR

2) Nobody will change unless the price of carbon is increased by some greater amount, at which point everybody will all of a sudden change. The situation is exactly analogous to the TV example. Except, that where nobody (I hope!) would argue for scenario 2) in the TV case, I have seen any number of otherwise sensible people arguing for #2 in the carbon case.

Some examples:

Stehpen Rees (who I'll give credit to for at least admitting that it is a start): "Most commentators agree that in order to influence consumer behaviour a carbon tax has to be around $30 per tonne."

Sacha (who does include the weasel-word materially, on which he might mount a weak defense): "I do not believe that 7.23 cents per litre of gasoline will materially change people’s behaviours toward consuming gasoline (presumably through driving)."


Raphael Alexander
: "Shorter answer: carbon taxes of this size are too insignificant to reduce anything but the cash flow of the poorest working Canadians, while creating no incentive to reduce emissions"

(credit to MarkCH in the comments on Alexander's post, for laying out the marginal argument, even if nobody actually engaged his comments).

Robert (responding to Mark): "These taxes will have a marginal effect on consumption among marginal consumers.

If by marginal you mean none, then I agree."

And of course, you can always rely on the National Post to be the most clueless of all, with a headline that reads: "B.C.'s carbon tax won't change consumer habits"

Maybe people are just trying to say that the increase is so small that the impact really will be immaterial, or maybe people are disappointed because they thought that the first implementation of a carbon tax would be so huge that it would immediately force everyone to make drastic changes to their lifestyle (or vote out the government which implemented the tax, get the tax removed and carry on), but it comes across to me as thinking that there is some magic threshold which has to be crossed before anything changes, and that is simply not the case.

----
One other comment I have, which Rees makes as well, is that people really don't seem to get the idea of a revenue neutral tax. I've heard many many folks talking about the increased costs from the carbon tax and how they will be passed on to the consumer, but almost nobody who mentions the flip side which is that with other taxes dropping to offset the carbon tax, those businesses with a small carbon footprint (the ones we want to encourage to grow) will have lower costs, which they too will presumably pass along to customers.

---
Back to my main point, this is certainly not the first time I've encountered this widespread inability to grasp the concept of marginal changes in behaviour, it seems to arise regularly on both the left and right wings whenever someone wishes to claim that a government policy will not have any impact. I've never really known what to make of this blind spot, but I was reading Steven Pinker's excellent book, 'The Stuff of Thought' last year, and he made a point which I think might at least provide a partial explanation:

"Humans have a primitive concept of number, which distinguishes only one, two and many, though they can estimate larger quantities approximately. They use this coarse way of quantifying not just when tallying objects (as in 'singular', 'dual' and 'plural') but also when locating things in space (as in 'at', 'near' and 'far') and when locating things in time (as in 'the present', 'the recent past', and 'the remote past')." (from p. 429)


Perhaps it is this instinct to classify things in a discrete fashion ("at" or "near" )rather than a continuous fashion ("1 metre away", "10 metres away") which leads people to reason that a policy or tax is either "enough" or "not enough" to change behaviour, as opposed to the change in behaviour scaling with the magnitude of the size of the carbon tax. Who really knows, but it's a possibility.

Anyway, yeah, this post is a little obnoxious, but we're pretty much doomed, and we're extra doomed if politicians get nothing but grief when they come out and do the right thing. And sure, a carbon tax which totals $30/tonne won't be enough on its own to cause the necessary reductions in greenhouse gas emissions, but nobody, including the government, is claiming that it is. It's a start, it's a precedent, it's a part of a larger framework of initiatives, and it's something people should support if they're serious about fighting climate change.


---
* Actually, in microeconomics they usually put price on the y axis and quantity sold on the x axis, but I'm used to seeing the independent variable (price, in this case) on the x axis and the dependent variable on the y axis so I flipped the axes.

16 Comments:

  • Hey Declan,

    Is there a cartoon out there for when you stay up all night going around to everybody you thought was wrong but now agree could be right?

    Or some such thing.

    .

    By Blogger Gazetteer, at 10:29 PM  

  • Hey, Declan - Excellent post.

    Made it easy for even those of us who stopped at Econ #101 to understand!

    By Blogger West End Bound, at 7:08 AM  

  • On the face of it, and from a purely theoretical point of view, it's hard to disagree with your thesis Declan.

    Still, I think that Dubner and Levitt, not Pinker, are the guys you need to listen to on this file.

    Explanation follows:

    Considered in terms of the tax/price dichotomy the supply/demand curve should work exactly as you describe…but it’s not that simple.

    The problem is that the real world just doesn't shake down that way - if consumer behavior is going to change, and I'd assert that it has to - you have to take into account a whole range of marginal situations that your scenario ignores.

    This is especially true in the Lower Mainland/Fraser Valley and that's where the changes have to take place.

    In order to change consumer behaviour the only expedient that works is a dull instrument and the shock of a very heavy hit - the kind of thing that the energy crisis of the 70s delivered.

    If consumer behavior changes in the near future, it won't be because of the carbon tax (although the government will certainly try to take credit for it) it will be because of the impact of an international economic and financial meltdown accompanied by a significant and permanent increase in the wholesale price of oil.

    This carrot and stick nonsense in the budget is sophistry - the tax burden on business in BC is already largely lost as a lever to induce change - Campbell made sure of that when he first came to power. The hundred buck bribe is, as others have already noted, just a bribe.

    Complicating and negating the government's commitment to real change was another feature of the same budget - only Will Horter of the Dogwood Initiative (to my knowledge) has noted that the budget contains some serious contradictions in that it provides subsidies for oil and gas exploration, and supports highway and pipeline building, while trying to reduce carbon emissions.

    All pretty schizophrenic and facile, in my view: In its attempt to please everyone I think we'll find that Gordon Campbell has managed to actually DO very little. Just like the absurdity of their policy from 2005 to buy all new hybrid vehicles for government fleets – which looks great when you see all the Prius’s in the motor pool – as long as you ignore all the brand new high-displacement pickups in several other ministries.

    If the international price of oil falls, the administrative cost of all this nonsense will be the only real effect of the 'carbon' plan.

    Sorry, but that's the way I see it.

    Like early attempts to use incremental price increases in taxes to curb smoking, the Liberals are going to have to start using many other bigger levers before they exert much influence on a product for which the demand is all but inelastic.

    It'll all be decided elsewhere, I'm afraid. Perhaps, if the international price of oil goes down, it will be far too late in the day……

    By Blogger G West, at 7:33 AM  

  • Gaz - I don't think so. Better just get some sleep. I hope this budget will mark the start of effective government action on this file, but that will still take a lot of work.

    W-E-B - thanks.

    g west - I'd write a rebuttal to your comment, but I'd just have to repeat my post. I'm not sure comparing the carbon tax to the early stages of the campaign to reduce smoking rates - one of the most successful behaviour changing initiatives ever implemented by government, is a good way to make the case that the government is not on the right track here.

    By Blogger Declan, at 12:32 AM  

  • Clearly you've misunderstood.

    I'll try to explain.

    The point isn't that the anti-smoking campaign hasn't been successful. Which is exactly why I said this: 'Like early attempts to use incremental price increases in taxes to curb smoking'. In fact, for the first several years of that campaign it was a classic textbook example of the fact that demand for some kinds of 'addictive' products is not at all sensitive to price.

    Our demand for hydro-carbons and personal transportation independence is, in my view, an almost perfect analogue. In fact, as I also pointed out, it was only the hammer blow of a much more significant rise in the price of gasoline at the pumps (in real dollar terms) at the time of the 1970 oil crisis that actually did change consumer behavior and motorists choices.

    It certainly has been; but, if you look at the attenuated period over which the change has taken place, I think you'll understand what I was trying to get at.

    Smoking has been reduced to its current levels over a period of approximately a generation and a half - the classical inelasticity of demand for the cancer sticks has been proved beyond doubt - and the coffers of the taxing authorities are full of the evidence of that too.

    All climate change theory I've read strongly implies that, in order for the change in behavior to be effective and to avoid the climate tipping point, the production of GHG has to drop significantly in short order - not level off over the next two decades.

    Moreover, that's the rub.

    Perhaps I didn't explain it clearly enough:
    In my view then, in order for carbon tax regimes to succeed they have to provide the kind of instant knock out blow to the behavior being targeted, and this half-hearted effort won't deliver that kind of punch.

    As I said, a rise in the international price of oil may do the trick but it would be dishonest for anyone to suggest that the BC government's half-hearted and so-called revenue neutral effort will have anything much to do with it.

    Furthermore, unless the revenue from the sin tax is directed at correcting or ameliorating the sinful behavior, it won't actually be part of the solution.

    In that sense, in so far as the revenues of tobacco taxes have been used to address other aspects of smokers' behavior, the effort has been successful - over time.

    The 'revenue' from the carbon tax - rather than being passed back into circulation as the current legislation contemplates (through tax savings and bribes) should instead be invested in addressing the problem - getting people out of their cars and providing them with greener transportation options.

    The impact and direction of the current government's effort is exactly and precisely the opposite of what it should be. If this is the crisis that it seems to me – these kinds of pusillanimous efforts aren’t going to succeed in the available time frame; in fact, widening roads and building freeways is exactly the wrong kind of thing to do and 7c a litre ain’t gonna matter a damn..

    By Blogger G West, at 11:27 AM  

  • I understood just fine.

    It seems as though your complaint is that the government didn't in one sudden change introduce all the changes and new rules and taxes necessary to cut back emissions by say 50% in the province in a few years.

    Which is true, but I believe that one has to be realistic about these things. B.C. is now the leader in north America on this file, and complaints should be directed at those laggards in other jurisdictions who are holding back further change.

    For just one example, already people drive across the border to get cheaper gas in Washington state - there is a limit to how much B.C. can act at once, and on its own, and I think they are already pushing it.

    I believe that your type of 'all or nothing' thinking is a common flaw within the environmental movement, where positive changes in the needed direction are criticized and derided because they are not 'the prefect solution' or won't solve the problem instantly. What is needed instead is positive encouragement and reinforcement of positive steps taken, so that it becomes politically rewarding for more action to be taken.

    By Blogger Declan, at 1:22 PM  

  • That may well be true of environmentalists - but the point you were making was that this is a simple case of micro-economic supply and demand.

    I don't believe it is.

    I'm not really an environmentalist - I disagree with your economics - and probably your politics – but we’ll let that go for the moment.

    The reason folks go across the border for gas is a combination of price and location and, like all addicts, the carbon tax isn't going to change that - just make it worse.

    That's why a complex situation involving addictive behavior isn't subject to the normal textbook rules of classroom economics. The only way to address climate change - if you believe it is a serious problem - is by creating the moral equivalent of war.

    In such cases, change can be effected within the necessary time parameters to save the situation. I see more concern for the preservation and advancement of the government's gateway strategy with its increased emphasis upon highway traffic and freeways than I do for the health of the environment – not to mention the stimulus and tax treatment of oil exploration in the same budget.

    I'm not saying that I agree with the crisis approach - I am saying that's it is sophistry to pretend that the current effort is anything but window dressing. Check with me in five years time, if the international price of oil starts to sag as the economic conditions worsen as I suspect they will, the idea that these measures are going to be simulative and positive will be quickly forgotten.

    Like virtually everything the Campbell government has done since 2001, the main push behind this effort is his predilection NOT to stand for anything but business as usual.

    You also haven't addressed the fact that I suggested the necessary financial impact to start some real change may well come from increases in the international price of oil...it won't come from the Campbell plan. Although it is pretty clear he (and apparently you too) will attempt to take credit for it if that does happen – which would be, I’d assert, profoundly dishonest.

    Anyway, thanks for the exchange.

    Though I disagree with your conclusions, I appreciate the fact that you're not unwilling to discuss them.

    Cheers.

    By Blogger G West, at 1:51 PM  

  • Yes, thanks for the exchange. I stand by the fact that microeconomics applies as normal here. Sure, demand for carbon is inelastic in the short term. Changing your lifestyle to reduce carbon usage takes more time than changing what type of juice you buy, but price changes (even small ones) have their effect all the same.

    The carbon tax is (for now) $30/tonne. If global markets drive up the price more than $30/tonne they will have more impact than the tax. If they don't they won't. This is consistent with my original post with a demand curve which responds to price changes.

    There are lots of other factors at work beyond simply prices of course. Changes to building codes to improve efficiency, municipal plans that increase density and reduce sprawl, higher electricity rates and expansion of wind and hydro power, a cap and trade system for large emitters, capping of landfills to capture methane, expanded transit systems, and tougher vehicle emission standards is just a list of what comes to mind off the top of my head as far as other factors at work goes.

    With so many pieces moving at once, we'll never be able to sort out which measures had which effects exactly.

    By Blogger Declan, at 2:03 PM  

  • Just one other small thing and then I’ll leave this to others.

    I should have mentioned that, from my reading of the reaction to the budget, most 'environmentalists' as you call them, appear to be quite sanguine about the results of Campbell's plan.

    Therefore, I'm not sure whom you're talking about when you write the following:


    I believe that your type of 'all or nothing' thinking is a common flaw within the environmental movement, where positive changes in the needed direction are criticized and derided because they are not 'the prefect solution' or won't solve the problem instantly.

    In fact, most eco/green groups and thinkers have been positively effusive in their praise.

    Like you, and much of the working press, all seem to have been, once again, effectively and comprehensively gulled by the words of a green shod finance minister with even less economic smarts than the average truck driver.

    She knows, with all the certainty of someone who works for a living, that that isn't going to change the amount of gas or diesel he pumps into his rig one tiny bit.

    By Blogger G West, at 2:13 PM  

  • You got the microeconomics right, but

    - in order for most people to switch modes (change from driving to riding the bus) there has to be a worthwhile alternative. For the majority of the Lower Mainland it isn't, and the plans to make it better are too little, too late and in the wrong places.

    - for a price change to have any measurable effect, people have to be aware of it. The pump price of gasoline is so unstable that when then carbon tax is applied no-one will notice. It will have risen since the announcement anyway.

    On the other hand (and economists always say that) the fuss about the carbon shoudl make poeple expect to see rising prices for the long term, and that shoudl have some effect on trip making. They may combine more trips, or be more ready to think about ride sharing. How much that is due to the carbon tax and how much to increasing shortages of oil supply doesn't really matter.

    By Anonymous Stephen Rees, at 4:09 PM  

  • Excellent post Declan. I think you're right. In particular I think you're right about the motivation for taking incremental steps to get to a 'market' price per tonne of CO2.

    By Blogger KevinG, at 4:31 PM  

  • Elasticity < 1

    In this case, the change in quantity demanded is proportionately smaller than the change in price. An increase in price would result in an increase in revenue, and a decrease in price would result in a decrease in revenue. In the extreme case of elasticity near 0, the demand curve would be nearly vertical, and the quantity demanded would be almost independent of price. The case of zero elasticity is described as being perfectly inelastic.


    From this demand curve, it is easy to visualize how even a very large change in price would have no impact on quantity demanded.


    My assertion stands, the demand for oil/gasoline is nearly perfectly inelastic.

    Sorry, but them's the breaks - only a big whack on the head or a sudden shortage (a la 1970s) is going to change behavior.

    The carbon charge on gas is a pig in a poke.

    By Blogger G West, at 1:31 PM  

  • sorry the graph I provided didn't print...suffice to say the curve is perpendicular to the y-axis in the case where a demand for a good is perfectly inelastic and therefore not responsive to small changes in price.

    By Blogger G West, at 6:14 PM  

  • Perhaps you'll indulge me if I post just one more link:

    http://canadianpress.google.com/article/ALeqM5gt9w1B6K7POuQ1fB3Ax0q_bBlxgQ


    Now I really am outta here.

    Cheers Declan

    By Blogger G West, at 9:26 PM  

  • For the record - that's perpendicular to the x-axis and parallel to the y-axis...not that anyone's paying any attention at this point. Sheesh!

    By Blogger G West, at 1:37 PM  

  • Hello Declan

    To you and Gwest: The elasticity of demand for carbon-producing activities is an empirical question, one that can be answered by studies such as some of the 407 in the EConLit database for "elasticity" in descriptor. There wasn't one with "fossil fuels" as a keyword, but of the five meta-analyses you might want to read the article by Molly Espey "Explaining the Variation in Elasticity Estimates of Gasoline Demand in the United States: A Meta-Analysis" in Energy Juornal 17/3 (1996): at pages 49-60 on factors that make estimates differ and concluding that overall the estimates are robust (though the abstract doesn't say what they are)

    Best Wishes,
    Alan

    By Anonymous Anonymous, at 6:06 PM  

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