Good graphs are general, or how a carbon tax is like drug legalisation

By Eric Crampton 25/10/2012 2

Stephen Gordon ably makes the case for market mechanisms over regulatory approaches to dealing with climate change. The deadweight costs of achieving any arbitrary level of greenhouse gas reduction are lower either under emissions trading or a carbon tax as compared to using regulations like “You must use Technology X” or “You may not use Technology Y.”.*

Stephen illustrates with a couple of handy graphs. They’re also graphs that I use in my Economics and Current Policy Issues class, but in an entirely different context.

Here’s the welfare effect of a regulatory approach. Stephen writes:

Regulations essentially have the same effect of a technical setback: they oblige suppliers to undertake practices that increase the cost of production. This has the effect of shifting the supply curve up: Faced with higher costs, producers are going to raise the minimum price they’ll accept for any given quantity produced. This upward shift increases prices and reduces quantities produced, which is of course the policy goal. It also affects the producer and consumer surplus:

He then explains why the welfare loss is the entire green trapezoid, before illustrating the alternative approach:

Suppose now that instead of regulations, the government imposes a tax on the sale of the good. This also shifts up the supply curve, as producers will now require prices that offset the extra cost of the tax. The difference here is that government revenues are now introduced into the graph:

A good chunk of what was deadweight cost is now crunchy tasty tax revenue.

I use exactly the same graphs to illustrate the superiority of tax based approaches over drug prohibition in my Economics and Current Policy Issues course at Canterbury. Prohibition is a negative technology shock for producers involving real increases in production costs. The same consumption reduction can equivalently be achieved by a legalised system that uses taxes as consumption deterrent, and with a similar transformation of deadweight cost into tax revenue. You can make it more complicated by saying that the demand curve shifts out under legalisation and by noting that there are tax levels beyond which you induce black market providers to enter the system; I take these as suggesting you can’t really have a retail price under legalisation that’s above the current black market price. Whether we then have any substantial consumption increase is more of an empirical question; Portugal’s experience suggests it not to be the case.

* I still put reasonable weight on that this may not be the best approach for New Zealand. If everyone in the world were doing carbon trading or carbon taxes, we’d want to as well. But, realistically, if New Zealand were to disappear into outer space tomorrow, it’s pretty unclear that the entire abolition of New Zealand’s net greenhouse gas emissions would do much on aggregate warming outcomes. Maybe we’d delay the onset of any particular level of GHG accumulation by a half day over a century. In that case, New Zealand could perhaps do better by picking high variance plays despite their lower expected mean. Pour money into biotech research for low GHG pastoral systems and give the resulting technology away to anybody who wants to use it. Lower expected returns, but if it pans out, it could reduce GHG emissions by a heck of a lot more than NZ could achieve on its own via domestic incremental reductions in carbon or methane emissions.

2 Responses to “Good graphs are general, or how a carbon tax is like drug legalisation”

  • Eric, can ask about the provenance of your view that “it’s pretty unclear that the entire abolition of New Zealand’s net greenhouse gas emissions would do much on aggregate warming outcomes.”?
    Is that you speaking in terms of resource economics? Does it flow from Tom Tietenberg or Robert Stavins? Is it from Samuelson? Keynes perhaps?

    • Well, as best I can tell, New Zealand is responsible for somewhere on the order of a titch over 0.1% of aggregate net greenhouse gas emissions. So, if over the course of a century, New Zealand failed to exist, we’d save 12% of 2008 output, or about 47 days. Put in any accounting for that developing world emissions are likely to grow rather more quickly than New Zealand’s over the course of the next century and you’re down to delaying global GHG accumulation by a few days if New Zealand disappeared. A month, tops. As ballpark. But I’m more than happy to take other numbers if you’ve got better ones.

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