Among other things, morality is a bunch of heuristics that work pretty well -- often better than explicit calculation, given our limitations -- to produce outcomes that are better for all concerned. (Of course they don't always work.) One reason why the heuristics can work better than explicit calculation is that they take into account (albeit fuzzily and inaccurately) things that may get missed completely in our explicit calculations.
For instance: We tend to think of monopolies as morally bad. But that isn't just because they produce too little of their product and keep prices high. It's broader than that: the intuition is more that they have "too much power" and we don't trust their motives.
For instance: We tend to think of polluting firms as morally bad. But that isn't just because they produce too much of their product. In fact, it isn't at all because they produce too much of their product. If they could produce 10x more of the product without polluting more, that would be just fine. It's because they are doing something harmful -- and because their choice to do that might indicate that they'd be willing to do other harmful things too, if it increased their profits.
Put those two together. A polluting monopoly has too much power and too much willingness to do harmful things. That's a bad combination. Even if they do better than a polluting non-monopoly or a non-polluting monopoly at producing the optimal amount of their product.
For instance: You can change your level of pollution by other means than making more or less product: you can, for instance, change your manufacturing processes. A company that cares about its public image may pollute less in order to preserve that image. A company that demonstrably doesn't mind polluting, and that doesn't need to care about its image to keep its sales up, is unlikely to do that.
For instance: A company that doesn't care about harmful externalities, and that can afford to be inefficient because it has a monopoly, may be more willing to engage in other socially harmful behaviour: bribing politicians (more or less openly; in Western democracies one common way is to offer board seats or lucrative advisory positions to ex-politicians who have voted the "right" way), making products that are themselves harmful, reducing the quality of their product without lowering prices in order to take more profit, etc.
Economics is not a morality tale. But sometimes it is something worse.
The real life example here is electric utilities. The way they're regulated they charge a kWh price roughly equal to the average total cost (let’s say about 12 cents). The proper way to price would be at the marginal cost (at around 4 cents). The fact that marginal costs are below average total costs are what makes them a natural monopoly.
The somewhat obvious better solution would be to charge marginal cost for each kWh and then have some other method to collect the massive fixed costs. But for whatever historic reasons, we don't do that and most (all?) utilities price each kWh at about the average total cost. This means that as a society our quantity demanded kWh is way below where economic theory says it should be.
However, there is probably a fairly substantial pollution/CO2 externality to producing electricity. Without some analysis it isn't obvious whether we're producing too much electricity or too little.
I did try once to look at estimates of the size of the externality to see if it made up for the pricing way above marginal cost issue and the preliminary results were that the externality was smaller (meaning, global warming considered, we're still not using enough electricity). However, there were a couple of points I'd need to get into deeper.
1) The pricing above marginal cost issue is greatest for residential rates and smallest for industrial rates. I was looking at residential rates. Using the same cursory analysis on industrial rates would mean that we're over using electricity in industrial sectors.
2) The carbon externality number I used from the EPA seemed to be derived by figuring out how high the price of electricity would need to be to get usage down to the level they wanted. Under correctly priced utility rates (i.e., priced at the marginal costs), their analysis may have had a much higher $ / kWh externality number. But at the same time, I’m a little suspect of that method of calculating the externality as it would indicate if the cost of production halved it wouldn’t be optimal for society to produce more. So I’d need to do some more research to make sure I’m using good pollution/CO2 numbers.
I haven't seen this issue discussed by people like Mankiw when they talk about the Pigou Club and I think it probably should be. If there's interest I could probably write this up a bit more formally and make it a post.
There exists much better work than that on power production externalities. ExternE, for starters. Which mostly prove that the amount of pollution has remarkably little to do with how much power you produce, and a heck of a lot to do with which technologies you use to produce them. Major takeaway if you do not care to read that "Coal is not a good idea, even ignoring the carbon.".
A couple of points.
This doesn't apply in all countries. In UK for instance, it is common to have a standing charge (flat fee per day) as well as a usage charge (fee per kWh). Or some utilities charge a high price for the first few kWh, and then a lower price for subsequent kWh, which has a similar effect. See here for some details.
Even where there is a single price (a price per kWh) it is not true that the "correct" market price is just the marginal cost. Suppliers do need to recover their costs of capital, and fixed costs, or they will go out of business. Imagine a market with a huge numbers of suppliers, where the price drops to marginal cost. They will all be losing money, but some will go broke quicker than others. As suppliers exit the market, the remaining suppliers find they can increase their price, and equilibrium is established when some marginal supplier is just hanging on in the market (barely making enough revenue to cover total costs). If the number of suppliers drops below this equilibrium, then they all start making large profits, but this situation should attract a new entrant into the market, so restoring equilibrium. That's how the market theory works of course: real life situations create both barriers to entry (overregulation, obstruction of access to wholesale supplies, or to the distribution network) and barriers to exit (loss-making firms are propped up for years by subsidies, bailouts etc).
This doesn't apply in all countries. In UK for instance, it is common to have a standing charge (flat fee per day) as well as a usage charge (fee per kWh). Or some utilities charge a high price for the first few kWh, and then a lower price for subsequent kWh, which has a similar effect. See here for some details.
My perspective is US-centric, but from what I'm aware the per kWh price in most countries for most people is well above the marginal costs. Many places do have a daily or monthly charge but that tends to be $10 or less--not even close to high enough to recover all the fixed costs associated with a customer. Looking through some of the Scottish Power rates that you linked to, the daily charge doesn't get much higher than 30p. That helps mitigate the issue a bit, but it's still there. In that case, retail kWh prices--after the standing charge--is still over 10p / kWh. Wholesale rates look like they're 4.5p in the UK (which should be a good proxy for short run marginal costs) so there's still a big gap.
Even where there is a single price (a price per kWh) it is not true that the "correct" market price is just the marginal cost...
As far as I'm aware, economic theory says the "correct" price for electric utilities is lower than where the actual price is. It's probably easier to visualize on a graph like this one. (I'm saying the difference between Pf and Pr, at least in some cases, may be higher than the externality, which is a real-life example of what the op is talking about). If that's not standard economic theory though let me know as it's an area of interest to me.
The market correction mechanism you described works for most industries but electric utilities are typically treated as natural monopolies, the optimal number of suppliers is one. But even if that 's not true (i.e. it's not actually optimal), in many places regulation only allows one supplier so the market forces described couldn't work. The result is that the average /kWh price customers pay is higher than the average marginal costs (optimal society price) and it continues indefinitely because new firms can't come into the market. There isn't large profits made though because they're pricing at the regulated price (at the average total cost) and not at the monopoly price (again, easier to visualize on the graph linked to above).
It's probably easier to visualize on a graph like this one. (I'm saying the difference between Pf and Pr, at least in some cases, may be higher than the externality, which is a real-life example of what the op is talking about).
I think that, strictly, Stuart was arguing that the difference between Pm and Pf exceeds the externality cost, which may well be true. However, politically it is of course much easier to force a polluting monopoly to lower its price (to Pf) than to subsidise said monopoly still further. It is also economically more efficient (there are better things to do with public money).
You may also be right that the externality cost exceeds the difference between Pf and Pr - referring to the UK numbers, does the externality actually work out at less than about 5p per kWh? Even if it does, I'd argue that it is unrealistic to expect the price to drop to Pr and stay there indefinitely (while the suppliers go broke).
The "Correct" price for electricity is one price to be connected to the grid and several more relating to one's power used, power factor, peak demand, and the like.
The average price paid is lower than the "correct" price, because charging the "correct" price adds lots of measuring and billing costs. It's better to allow some subsidizing to be happening than to spend more just to make sure it isn't.
An easy way to do it would be to charge the "correct" marginal cost for all kWh and have a separate fixed fee. My water bill is something like $50 fixed and then a small amount for the water I use after it; the electric bill could work the same. Ronald Coase argued that here
Commercial meters have priced kW for a long time and I think the reason residential didn't was more along the lines of they're more homogeneous than the meter costs. But either way, it seems everyone is getting smart meters now and you could match it up to theory exactly if it were politically feasible.
The political problem is that some people would be charged more; regression to the mean suggests that those people would be the ones who currently pay the least. The people who pay the least are the people who use the least power.
In a proper cost-sharing setup, dividing the fixed cost of maintaining each portion of the grid among the people served by that portion of the grid, pricing would be fiendishly complicated and appear unfair: Consider ten rural houses roughly in a line sharing a single branch line from the distribution station: each of these houses would be charged equally for their use of the larger distribution network, but the first house would be charged with 1/10 the cost of maintaining the first segment of their shared circuit, the second house would be charged that plus 1/9 the cost of the second segment, and so forth.
Or is it: If someone builds an 11th house at the end of that line, and the added load requires that the first segment be upgraded (to a line with higher maintenance costs) to handle the additional load, how is that cost fairly distributed? (What if the 11th house is added in the middle of the line?)
A $X+$y/kWh system makes more sense, but there is no system which is perfectly fair and appears to be fair to most people.
The political problem is that some people would be charged more; regression to the mean suggests that those people would be the ones who currently pay the least. The people who pay the least are the people who use the least power.
Everything you say is true, but your implied argument is flawed (you are implicitly making an "all A are B, all C are B, therefore all A are C" argument). If we had a fixed fee, and were discussing the possibility of eliminating it, your argument would apply just as well.
Sorry- that made much more sense as a lead-in to the self-redacted segment where I pointed out that the higher-spending (and presumed higher-income) users were subsidizing the poor, and suggested that might be a feature.
I get the difference in country perspective, and the difference between a regulated local monopoly (which I believe you have in US) vs a market structure with a regulated distribution network, but a large choice of retail suppliers.
Incidentally, there are 6 large UK suppliers, and multiple smaller ones, so this is far from perfect competition, but also far from a monopoly. According to this report retail margins are about 7 per cent, and the previous margin was only about 3 per cent. Even in a "good year", the big six suppliers are making an average profit of around £100 per year on an average bill of around £1400 per year. So if the retail price dropped to 9 pence per kWh as opposed to 10 pence per kWh, the firms would probably be making a net retail loss.
While the current profit margin probably does encourage entry, I can't see any way that the retail price could drop to 4.5 pence per kWh and still allow a supplier to make a profit. It seems quite possible that a new supplier could start up offering 5 pence per kWh, and would rapidly grab market share: the fact that no-one in UK is trying that suggests that it just doesn't stack up as NPV positive.
Even where there is a single price (a price per kWh) it is not true that the "correct" market price is just the marginal cost.
In a competitive market, the correct market price is the marginal cost. If the market price is higher, the firm will profit by producing more; if it's lower, it will profit by producing less.
That is ignoring the fixed costs.
In the situation you describe (price = marginal cost), it may be impossible for the firm to make a profit; all it can do is minimise its losses, so that it "only" loses its fixed costs. However, since suppliers are making losses, the number of suppliers will contract i.e. this is not an equilibrium situation.
True, there are idealized models of "perfectly competitive markets" where all fixed costs, costs of entry, costs of capital etc are negligible. In that case, price will stay at marginal cost in equilibrium. But "competitive markets" are a bit more general than "perfectly competitive markets".
A slightly more detailed analysis looks at the "capacity" of the suppliers. Suppliers tend to have a marginal cost curve which is fairly flat over a certain range, but then climbs like a sheer cliff when they hit capacity. If every supplier is producing at or near to capacity, no-one makes extra profit from producing more; price is then determined by the demand curve (I.e. at what price will customers demand the current capacity?) Further, at equilibrium, supplier projects which aim to increase capacity will show up as NPV negative (because they are not expected to recover fixed costs, capital costs etc.) So these projects won't happen, and the equilibrium is maintained.
That is ignoring the fixed costs.
It's assuming the fixed costs can be recuperated. Large fixed costs don't mess up the equilibrium, if a firm can exit the industry and sell its initial investment at a comparable price to what they bought it for. It's large fixed investments that can't be liquidated that cause the problems.
In the situation you describe (price = marginal cost), it may be impossible for the firm to make a profit; all it can do is minimise its losses, so that it "only" loses its fixed costs.
The price=marginal cost is a consequence of homogeneous products (technically, of the fact that each individual firm faces a flat demand curve). The rate of profit is connected with ease of entry and exit. These are two separate things.
It's assuming the fixed costs can be recuperated... if a firm can exit the industry and sell its initial investment at a comparable price to what they bought it for
That sounds like assuming no depreciation and no cost of capital, right?
Otherwise, imagine a firm considers increasing its capacity via investing in a productive asset, for an upfront cost A. There is a depreciation rate d, and a cost of capital (interest, dividends etc) of c. If the firm sells the asset after r years, then its sale value in year r will be something like A x (1 - d)^r, and the present terminal value will be something like A x ((1 -d)/(1+c))^r.
So in the business pan, the firm should assume a fixed cost not strictly of A, but rather of A x (1 - ((1-d)/(1+c))^r). If (d+c)r is roughly 1 or more then this will be about A; only if (d+c)r is much less than 1 can this cost be ignored.
As | understand it, it assumes no or low depreciation, but says nothing about the cost of capital. The definition of "profit" that I've been using is "extra profit to the company after all investors have been paid at the rate the market would demand, and employee and entrepreneurs have been reimbursed for their time and effort".
if a firm can exit the industry and sell its initial investment at a comparable price to what they bought it for.
Who would want to buy the equipment to get into an industry with zero profit opportunity?
What about fixed operating expenses, such as the insurance on the capital investment? (Or equivalently, the cost of the risk associated with owning it)
Monopolies are bad because they can capture much more of the consumer surplus than they would otherwise, not just because they underproduce.
Which then becomes producer surplus. Producers are people too, and there's no god-given right to certain terms of trade.
Monopolies which efficiently reinvest their producer surplus in improving the product tend to be monopolies to which I object very little. E.g. Google.
Even if they don't, their shareholders and bondholders are still people whose welfare is valuable. True, there are some bad incentive effects, but the welfare transfer isn't intrinsically objectionable.
Sorry for the late comment, but I'm just running across this thread.
The question is not whether Google reinvests their producer surplus better than other monopolies. The question is whether Google reinvests their producer surplus more efficiently, i.e., for greater total benefit to society as a whole, than would all the consumers who would otherwise get that surplus as consumer surplus. That seems highly unlikely since the options for reinvestment open to even a large company like Google will cover a much smaller range of possibilities than the options open to the entire set of consumers who would otherwise receive the surplus.
(Admittedly, there is an effect here in the other direction: Google has much more leverage than the average consumer. But I don't think that outweighs the effect I referred to above, because Google is not being compared to the average consumer; they are being compared to the sum total of activities of all consumers--more precisely, all consumers who would otherwise receive the surplus Google is getting.)
Economic theory isn't a morality tale because we use it for figuring out what different economic polices will result in, as opposed to whatever it is morality tales are for.
If we're going to talk about what people often do, I should add that people often warn about economics "not being a morality tale" and then go right on moralizing in different language ("we shouldn't let bondholders being able to stall a recovery...").
Or, a better example, "pollution is bad".
I think if you look at the actual medieval literary genre of morality tales, you'll find that it's specifically in the context of virtue ethics. In fact, the characters are usually embodiments of specific virtues and vices. It strikes my ear very strangely to hear what would presumably be a utilitarian economic argument (regarding stalling the recovery) described as a "morality tale".
I don't get your better example. People only rarely invoke economic morality tale arguments to reach 'pollution is bad'. I've seen public health arguments (pollution kills and causes disease in humans and poisons our food sources). I've seen direct morality arguments (the above plus killing and causing disease in animals and plants). I've seen economic impact arguments (Public health argument put in monetary terms).
I haven't seen an argument that skipped the public health argument, hit the economic impact, then looped from there into morality.
(morality and economics agree here)
I am sorry, which morality is that? I know of a whole bunch of different moralities with rather different views on many issues.
Soviet factories polluted far more while producing far less.
The formula isn't "Five units of pollution per unit of good produced" - that is, the amount of pollution produced is not dependent on the amount of goods produced. Your post assumes this is the case.
Additionally, "natural" monopolies (as opposed to government-instituted monopolies such as Bell) such as Standard Oil -didn't- underproduce. They can't afford to.
Additionally, "natural" monopolies (as opposed to government-instituted monopolies such as Bell) such as Standard Oil -didn't- underproduce. They can't afford to.
I find this difficult to believe. Consider the most extreme example of a natural monopoly: a software company. The marginal cost is $0. This isn't quite realistic, but let's assume for the sake of argument that everyone wants what they produce at least a little. In order to not underproduce, they'd have to give everyone their product. Unless they have some way of distinguishing people who are willing to pay $10 from people who are only willing to pay 1¢, they can't charge more than 1¢ without underproducing, but this won't give them enough money to offset the cost of producing the product.
Underproduce: A potential customer is willing to buy something for more than the cost to produce it, yet the thing isn't produced.
A monopoly gets to choose what price it offers to sell its goods at. If it raises its price, it gets fewer buyers but makes more money per buyer. The profit-maximizing price point is usually not equal to marginal cost, which means that the price will be too high for some people that could have been profitable customers (if not for the fact that selling to them would require the monopolist to make less money from everyone else).
That definition, if minimized, leads to economic waste, because it fails to reflect opportunity costs.
To illustrate with an example, my absolute favorite soda of all time is Mountain Dew Pitch Black II. It is also one of the most hated flavors among most people I've met who tried it.
There exist sufficient customers who like Mountain Dew Pitch Black II for Pepsi to make a profit producing it. Are they losing money by not producing it?
As it transpires, no. There exist -many more- customers for -other- flavours of soft drink Pepsi could be producing. Pepsi doesn't have unlimited manufacturing capacity; they use the same equipment to produce a wide range of drinks. The opportunity cost of producing Mountain Dew Pitch Black II is that they -aren't- using that equipment to produce a more popular flavor. So I'm out of luck, and the limited run is all they produced. (There was a Pitch Black I and a Pitch Black III, neither of which I had opportunity to try; Pitch Black III had an even more limited run than Pitch Black II.)
Producing Pitch Black II would be a -waste of resources-, in spite of the fact that it could be profitably manufactured. In terms of utility, it is a suboptimal utility-maximizing strategy.
So if we're using underproduction as some kind of moral yardstick, I think it's rather flawed, on account that we wouldn't actually prefer the universe in which underproduction didn't happen.
That definition, if minimized, leads to economic waste, because it fails to reflect opportunity costs.
Sorry. In the context of microeconomics, "cost" usually means "opportunity cost" and I didn't realize I needed to say this explicitly. Dollar costs are usually a pretty good proxy for opportunity costs in many cases, though...
If cost includes opportunity cost, your entire second paragraph ceases to be meaningful, because the cost would necessarily include the opportunity cost of not having priced the good higher and made higher profits. Using opportunity cost as your cost means this kind of underproduction is impossible; your marginal cost is whatever cost would result in the maximum profits.
Your entire post consists of explaining the meaning of an assertion, rather than explaining its basis. Why would you think that "cost" does not include opportunity cost?
And I don't see why it's accurate to say the Pepsi doesn't have unlimited manufacturing capacity. Yes, their current manufacturing capacity is limited, but you didn't give any explanation for why they can't build more equipment. Without such an explanation, this makes as much sense as saying that it wouldn't be profitable for me to run a home bakery business because there amount of flour in my house is finite.
The cost to build special equipment for this Pitch Black might be covered the absolute sales of Pitch Black, but it is doubtful that it would cover the slight increase in sales vs standard Mountain Dew - I imagine that Pitch Black drinkers would buy less standard Mountain Dew (or, failing that, other Pepsi products) if Pitch Black were available.
Soviet factories polluted far more while producing far less.
These are points about economic theory, not necessarily about economic fact. And I'm pretty sure you could find an example that goes along with this, maybe in some tiny industry; it's not as if polluting industries and government subsidies are in short supply, and mini-monopolies are quite common, so an example of this has to exist somewhere.
Additionally, "natural" monopolies (as opposed to government-instituted monopolies such as Bell) such as Standard Oil -didn't- underproduce. They can't afford to.
Standard economic theory says the opposite.
Now the theory may be wrong, but I stand by my point that economic theory is not a morality tale.
Your point may or may not be accurate, but it's not made by the post. Your post at the minimum comes across as being dependent on two facts which are not in evidence.
I'd suggest fleshing it out with more abstract reasoning; your argument literally consists of an example. You don't even explain what exactly it is your examples are supposed to be demonstrating. I -think- your point is that there isn't a single unifying moral perspective in economics - that is, there are trade-offs and opportunity costs in economics, including in the moral sphere. I agree with that point, if that's the point you're making. I just don't think your post does a good job making the point as-is.
If a company is not paying the true cost of the pollution they produce, then they may well be selling their product cheaper than they otherwise would, and thereby selling more of it.
However the amount they sell isn't the thing causing a problem for society. It is just a symptom. In this case, you can't fix the root problem just by treating the symptom.
The problem is that the profits of the company are not correctly tied to the problems they cause, and they therefore have insufficient incentive to invest in ways of reducing the problems (by, for example, buying a different raw material that is slightly more expensive, but far less polluting).
Other factors causing them to reduce production or increase the price they charge customers won't get them to change their behaviour on which raw material they buy.
(For clarity: yes, I know I'm ignoring that increased production is magnifying the effect of the pollution per item.)
economics is not a morality tale
Yes it is with economic growth being the good guy and Adam Smith's invisible hand being his motivation.
The invisible hand causes firms that pollute to produce too much, but the invisible hand causes firms that are monopolists to produce too little. Put the two effects together and you get a happy ending.
Comparing China under Mao vs Deng Xiaoping most certainly constitutes an extremely illuminating morality tale.
Comparing China under Mao vs Deng Xiaoping most certainly constitutes an extremely illuminating morality tale.
The tale is that following efficiency will produce better outcomes that following morality. The success of economics is essentially an anti-morality tale.
To act morally means to take actions which benefit other people. When Adam Smith's invisible hand is working properly markets will:
(1) Transfer resources to people who excel at helping others, (2) provide useful information (mainly prices) to people who wish to benefit others, and (3) create incentives for people to learn how to help others.
To act morally means to take actions which benefit other people.
To act morally implies taking actions which benefit other people under certain value systems.
For a second, much better reason why economics can't be a morality tale, see Elizabeth Anderson's recap of Hayek's argument:
In two of his important works of political economy, The Constitution of Liberty (see esp. ch. 6), and Law, Legislation, and Liberty (vol. 2), Hayek explained why free market prices cannot, and should not, track claims of individual moral desert.
Warning (in case you care): highly political.
I'm confused: Why are monopolies and firms which project more than zero negative externalities morally bad?
Because they move away from the social optimum: it is possible to make everyone better off without making anyone worse off, in those cases.
More colloquially, monopolies are bad because they drive prices up, and firms with negative externalities are bad because they emit pollution which kills you.
Does that reduce to "economically bad is morally bad"?
Is it economically and morally correct to spend $(x>1)*n dollars to remove a negative externality of $n? (For example, an airport which covers runway repairs by adding a surcharge to fuel sales will result in pilots who buy a lot of fuel for long flights subsidizing pilots who make lots of short flights. But charging a landing fee will require hiring someone to collect the landing fee; the fuel is self-serve.)
If the monopoly had sufficiently high fixed costs and decreasing marginal costs such that it made the most money at a price that is lower than the equilibrium price of a duopoly, would it still be economically bad? Would it still be morally bad?
Pollution, and other negative externalities, cause firms to produce too much of their product.
...if you fail to account for corporate reputations and government regulation.
The equilibrium behaviour for monopolies is to produce too little of their product, to keep prices and profits high.
That's why real economeis typically feature a Monopolies and Mergers Commission, or similar organization.
Example nicked from this online Berkeley lecture.
Monopolies are bad (morality and economics agree here).
Firms that pollute are bad (morality and economics agree here).
What about monopolies that pollute?
What about strong monopolies that pollute and receive government subsidies?
Well...
Pollution, and other negative externalities, cause firms to produce too much of their product. That's because they don't pay the full cost of the product, including the impact of pollution.
The equilibrium behaviour for monopolies is to produce too little of their product, to keep prices and profits high.
So a monopoly that pollutes is subject to two opposite tendencies: the unpriced-pollution tendency to produce too much, and the monopolistic tendency to produce too little. If the effects are of comparable magnitude, then the monopoly might be much closer to social optimum than a free market would be (the social optimum, incidentally, will generally involve some pollution: we need to accept some pollution in the production of fertiliser, for instance, in order to have enough food to stop people starving).
In fact, if the monopolistic effect is too strong, then the firm may under-produce, even taken the pollution effect into account. In that case, we can approach closer to the social optimum by... subsidising the polluting monopoly to produce more!!
And that, my friends, is why economics is not a morality tale.
