DRI-280 for week of 7-7-13: Unintended Consequences and Distortions of Government Action

An Access Advertising EconBrief:

Unintended Consequences and Distortions of Government Action

The most important cultural evolution of 20th-century America was the emergence of government as the problem-solver of first resort. One of the most oft-uttered phrases of broadcast news reports was “this market is not subject to government regulation” – as if this automatically bred misfortune. The identification of a problem called for a government program tailored to its solution. Our sensitivity, compassion and nobility were measured by the dollar expenditure allocated to these problems, rather than by their actual solution.

This trend has increasingly frustrated economists, who associate government action with unintended consequences and distortions of markets. Since voluntary exchange in markets is mutually beneficial, distortions of the market and consequences other than mutual benefit are bad things. Economists have had a hard time getting their arguments across to the public.

One reason for this failure is the public unwillingness to associate a cause with an effect other than that intended. We live our lives striving to achieve our ends. When we fail, we don’t just shrug and forget it – we demand to know why. Government seems like a tool made to order for our purposes; it wields the power and command over resources that we lack as individuals. Our education has taught us that democracy gives us the right and even the duty to order government around. So why can’t we get it to work the way we want it to?

The short answer to that is that we know what we want but we don’t know how government or markets work, so we don’t know how to get what we want. In order to appreciate this, we need to understand the nature of government’s failures and of the market’s successes. To that end, here are various examples of unintended consequences and distortions.

Excise Taxation

One of the simplest cases of unintended, distortive consequences is excise taxation. An excise tax is a tax on a good, either on its production or its consumption. Although few people realize it, the meaningful economic effects of the tax are the same regardless of whether the tax is collected from the buyer of the good or from the seller. In practice, excise taxes are usually collected from sellers.

Consider a real-world example with purely hypothetical numbers used for expository purposes. Automotive gasoline is subject to excise taxation levied at the pump; e.g., collected from sellers but explicitly incorporated into the price consumers pay. Assume that the price of gas net of tax is $2.00 per gallon and the combination of local, state and federal excuse taxes adds up to $1.00 per gallon. That means that the consumer pays $3.00 per gallon but the retail gasoline seller pockets only $2.00 per gallon.

Consider, for computational ease, a price decrease of $.30 per gallon. How likely is the gasoline seller to take this action? Well, he would be more likely to take it if his total revenue were larger after the price decrease than before. But with the excise tax in force, a big roadblock exists to price reductions by the seller. The $.30 price decrease subtracts 15% from the price (the net revenue per unit) the seller receives, but only 10% from the price per unit that the buyer pays. And it is the reduction in price per unit paid by the buyer that will induce purchase of more units, which is the only reason the seller would have to want to reduce price in the first place. The fact that net revenue per unit falls by a larger percentage than price per unit paid by consumers is a big disincentive to lowering price.

Consider the kind of case that is most favorable to price reductions, in which demand is price-elastic. That is, the percentage increase in consumer purchases exceeds the percentage decrease in price (net revenue). Assume that purchases were originally 10,000 gallons per week and increased to 11,200 (an increase of 12%, which exceeds the percentage decrease in price). The original total revenue was 10,000 x $2.00 = $20,000. Now total revenue is 11,200 x $1.70 = $19,040, nearly $1,000 less. Since the total costs of producing 1,200 more units of output are greater than before, the gasoline seller will not want to lower price if he correctly anticipates this result. Despite the fact that consumer demand responds favorably (in a price-elastic manner) to the price decrease, the seller won’t initiate it.

Without the excise taxation, consumers and seller would face the same price. If demand were price-elastic, the seller would expect to increase total revenue by lowering price and selling more units than before. If the increase in total revenue were more than enough to cover the additional costs of producing the added output, the seller would lower price.

Excise taxation can reduce the incentive for sellers to lower price when it is imposed in specific form – a fixed amount per unit of output. When the excise tax is levied ad valorem, as a percentage of value rather than a fixed amount per unit, that disincentive is no longer present. In fact, the specific tax is the more popular form of excise taxation.

The irony of this unintended consequence is felt most keenly in times of rising gasoline prices. Demagogues hold sway with talk about price conspiracies and monopoly power exerted by “big corporations” and oil companies. Talk-show callers expound at length on the disparity between price increases and price decreases and the relative reluctance of sellers to lower price. Yet the straightforward logic of excise taxation is never broached. The callers are right, but for entirely the wrong reason. The culprit is not monopoly or conspiracy. It is excise taxation.

This unintended consequence was apparently first noticed by Richard Caves of Harvard University in his 1964 text American Industry: Structure, Conduct, Performance.

ObamaCare: The 29’ers and 49’ers

The recent decision to delay implementation of the Affordable Care Act – more familiarly known as ObamaCare – has interrupted two of the most profound and remarkable unintended consequences in American legislative history. The centerpiece of ObamaCare is its health mandates: the requirement that individuals who lack health insurance acquire it or pay a sizable fine and the requirement that businesses of significant size provide health plans for their employees or, once again, pay fines.

It is the business mandate, scheduled for implementation in 2014, which was delayed in a recent online announcement by the Obama administration. The provisions of the law had already produced dramatic effects on employment in American business. It seems likely that these effects, along with the logistical difficulties in implementing the plan, were behind the decision to delay the law’s application to businesses.

The law requires businesses with 50 or more “full-time equivalent” employees to make a health-care plan available to employees. A “full-time-equivalent” employee is defined as any combination of employees whose employment adds up to the full-employment quotient of hours. Full-time employment is defined as 30 hours per week, in contradiction to the longtime definition of 40 hours. Presumably this change was made in order to broaden the scope of the law, but it is clearly having the opposite effect – a locus classicus of unintended consequences at work.

Because the “measurement period” during which each firm’s number of full-time equivalent number of employees is calculated began in January 2013, firms reacted to the provisions of ObamaCare at the start of this year, even though the business mandate itself was not scheduled to begin until 2014. No sooner did the New Year unfold than observers noticed changes in fast-food industry employment. The changes took two basic forms.

First, firms – that is, individual fast-food franchises – cut off their number of full-time employees at no more than 49. Thus, they became known as “49’ers.” This practice was obviously intended to stop the firm short of the 50-employee minimum threshold for application of the health-insurance requirement under ObamaCare. At first thought, this may seem trivial if highly arbitrary. Further thought alters that snap judgment. Even more than foods, fast-food firms sell service. This service is highly labor-intensive. An arbitrary limitation on full-time employment is a serious matter, since it means that any slack must be taken up by part-timers.

And that is part two of the one-two punch delivered to employment by ObamaCare. Those same fast-food firms – McDonald’s, Burger King, Wendy’s, et al – began limiting their part-time work force to 20 hours per week, thereby holding them below the 30-hour threshold as well. But, since many of those employees were previously working 30 hours or more, the firms began sharing employees – encouraging their employees to work 20-hour shifts for rival firms and logging shift workers from those firms on their own books. Of course, two 20-hour shifts still comprises (more than) a full-time-equivalent worker, but as long as the total worker hours does not exceed the 1500-hour weekly total of 50 workers at 30 hours, the firm will still escape the health-insurance requirement. Thus were born the “29’ers” – those firms who held part-time workers below the 30-hour threshold for full-time-equivalent employment.

Are the requirements of ObamaCare really that onerous? Politicians and left-wing commentators commonly act as if health-insurance were the least that any self-respecting employer could provide any employee, on a par with providing a roof to keep out the rain and heat to ward off freezing cold in winter. Fast-food entrepreneurs are striving to avoid penalties associated with hiring that 50th full-time-equivalent employee. The penalty for failing to provide health insurance is $2,000 per employee beginning with 30. That is, the hiring of the 50th employee means incurring a penalty on the previous 20 employees, a total penalty of $40,000. Hiring (say) 60 employees would raise the penalty to $60,000.

A 2011 study by the Hudson Institute found that the average fast-food franchise makes a profit of $50,000-100,000 per year. Thus, ObamaCare penalties could eat up most or all of a year’s profit. The study’s authors foresaw an annual cost to the industry of $6.4 billion from implementation of ObamaCare. 3.2 million jobs were estimated to be “at risk.” All this comes at a time when employment is painfully slow to recover from the Great Recession of 2007-2009 and the exodus of workers from the labor force continues apace. Indeed, it is just this exodus that keeps the official unemployment rate from reaching double-digit heights reminiscent of the Great Depression of the 1930s.

Our first distortion was an excise tax. The ObamaCare mandates can also be viewed as a tax. The business mandates are equivalent to a tax on employment, since their implementation and penalties are geared to the level of employment. The Hudson study calculated that, assuming a hypothetical wage of $12 per hour, employing the 50th person would cost the firm $52 per hour, of which only $12 was paid out in wages to the employee. The difference between what the firm must pay out and what the employee receives is called “the wedge” by economists, since it reduces the incentive to hire and to work. The wider the wedge, the greater the disincentive. Presumably, this is yet another unintended consequence at work.

ObamaCare is a law that was advertised as the solution to a burgeoning, decades-old problem that threatened to engulf the federal budget. Instead, the law itself now threatens to bring first the government, then the private economy to a standstill. In time, ObamaCare may come to lead the league in unintended consequences – a competition in government ineptitude that can truly be called a battle of the all-stars.

The Food Stamp Program: An Excise Subsidy

In contrast to the first two examples of distortion, the food-stamp program is not a tax but rather its opposite number – a subsidy. Because food stamps are a subsidy given in-kind instead of in cash – a subsidy on a good in contrast to a tax on a good – they are an excise subsidy.

Food stamps began in the 1940s as a supplement to agricultural price supports. Their primary purpose was to dispose of agricultural surpluses, which were already becoming a costly nuisance to the federal government. Their value to the poor was seen as a coincidental, though convenient, byproduct. Although farmers and the poor have long since exchanged places in the hierarchy of beneficiaries, vestiges of the program’s lineage remain in its residence in the Agriculture Department and the source of its annual appropriations in the farm bill. (Roughly 80% of this year’s farm bill was given over to monies for the food-stamp program, which now reaches some 47.3 million Americans, or 15% of the population.)

The fact that agricultural programs help people other than their supposed beneficiaries is not really an example of unintended consequences, since we have known from the outset that price supports, acreage quotas, target prices and other government measures harm the general public and help large-scale farmers much more than small family farmers. The unintended consequences of the food-stamp program are vast, but they are unrelated to its tenuous link to agriculture.

Taxes take real income away from taxpayers, but – at least in principle – they fund projects that ostensibly provide compensating benefits. The unambiguous harm caused by taxes results from the distortions they create, which cause deadweight losses, or pure waste of time, effort and resources. Subsidies, the opposite number of taxes, create similar distortions. The food stamp program illustrates these distortions vividly.

For many years, program recipients received stamp-like vouchers entitling them to acquire specified categories of foodstuffs from participating sellers (mostly groceries). The recipient exchanged the stamps for food at a rate of exchange governed by the stamps’ face value. Certain foods and beverages, notably beverage alcohol, could not be purchased using food stamps.

Any economist could have predicted the outcome of this arrangement. A thriving black market arose in which food stamps could be sold at a discount to face value in exchange for cash. The amount of the discount represented the market price paid by the recipient and received by the broker; it fluctuated with market conditions but often hovered in the vicinity of 50% (!). This transaction allowed recipients to directly purchase proscribed goods and/or non-food items using cash. The black-market broker exchanged the food stamps (quasi-) legally at face value in a grocery in exchange for food or illegally at a small discount with a grocery in exchange for cash. (In recent years, bureaucrats have sought to kill off the black market by substituting a debit card for the stamp/vouchers.)

The size of the discount represents the magnitude of the economic distortion created by giving poor people a subsidy in excise form rather than in cash. Remarkably, large numbers of poor people preferred cash subsidies to markedly that $.50 in cash was preferred to $1.00 worth of (government-approved) foodstuffs. This suggests that a program of cash subsidies could have made recipients better off while spending around half as much more money on subsidies and dispensing with most of the large administrative costs of the actual food-stamp program.

Inefficiency has been the focus of various studies of the overall welfare system. Their common conclusion has been that the U.S. could lift every man, woman and child above the arbitrary poverty line for a fraction of our actual expenditures on welfare programs simply by giving cash to recipients and forgoing all other forms of administrative endeavor.

Of course, the presumption behind all this analysis is that the purpose of welfare programs like food stamps is to improve the well-being of recipients. In reality, the history of the food-stamp program and everyday experience suggests otherwise – that the true purpose of welfare programs is to improve the well-being of donors (i.e., taxpayers) by alleviating guilt they would otherwise feel.

The legitimate objections to cash subsidy welfare programs focus on the harm done to work incentives and the danger of dependency. The welfare reform crafted by the Republican Congress in 1994 and reluctantly signed by President Clinton was guided by this attitude, hence its emphasis on work requirements. But the opposition to cash subsidies from the general public, all too familiar to working economists from the classroom and the speaking platform, arises from other sources. The most vocal opposition to cash subsidies is expressed by those who claim that recipients will use cash to buy drugs, alcohol and other “undesirable” consumption goods – undesirable as gauged by the speaker, not by the welfare recipient. The clear implication is that the food-stamp format is a necessary prophylactic against this undesirable consumption behavior by welfare recipients, the corollary implication being that taxpayers have the moral right to control the behavior of welfare recipients.

Taxpayers may or may not be morally justified in asserting the right to control the behavior of welfare recipients whose consumption is taxpayer-subsidized. But this insistence on control is surely quixotic if the purpose of the program is to improve the welfare of recipients. And, after all, isn’t that what a “welfare” program is – by definition? The word “welfare” cannot very well refer to the welfare of taxpayers, for then the program would be a totalitarian program of forced consumption run for the primary benefit of taxpayers and the secondary benefit of welfare recipients.

The clinching point against the excise subsidy format of the food-stamp program is that it does not prevent recipients from increasing their purchases of drugs, alcohol or other forbidden substances. A recipient of (say) $500 in monthly food stamps who spends $1,000 per month on (approved) foodstuffs can simply use the food stamps to displace $500 in cash spending on food, leaving them with $500 more in cash to spend on drugs or booze. In practice, a recipient of a subsidy will normally prefer to increase consumption of all normal goods (that is, goods whose consumption he or she increases when real income rises). Any excise subsidy, including food stamps, will therefore be inferior to a cash subsidy for this reason. In terms of economic logic, an excise subsidy starts out with three strikes against it as a means of improving a recipient’s welfare.

So why do multitudes of people insist on wasting vast sums of money in order to make people worse off, when they could save that money by making them better off? The paradox is magnified by the fact that most of these money-wasters are politically conservative people who abhor government waste. The only explanation that suggests itself readily is that by wasting money conspicuously, these people relieve themselves of guilt. They are no longer troubled by images of poor, hungry downtrodden souls. They need feel no responsibility for enabling misbehavior through their tax payments. They have lifted a heavy burden from their minds.

The Rule, Not the Exception

These common themes developed by these examples are distortion of otherwise-efficient markets by government action and unintended consequences resulting from the government-caused distortions. By its very nature, government acts through compulsion and coercion rather than mutually beneficial voluntary exchange. Consequently, distortions are the normal case rather than the exception. Examples such as those above are not exceptions. They are the normal case.

DRI-221 for week of 11-25-12: Free-Market Environmentalism

An Access Advertising EconBrief:

Free-Market Environmentalism

Stop a random passerby on the street and ask: “What are the three most important functions of government?” One of the answers would surely be: “To protect the environment.” Ask a sample of academicians “Why can’t we simply step back and allow markets to work freely and without interference by government?” and the leading answer would probably be: “Because the adverse effects on the environment would be too numerous and large.” Ask anybody what the biggest threat to the environment is and the answer will probably be something on the order of: “Greedy corporations and businessmen.”

The linkage between free markets and the physical environment may be the most misunderstood relationship in all of economics. It is often overlooked even by professional economists. To the general public, it is a complete mystery.

The Roster of Environmental Disaster

If government action is required – or thought to be required – to protect the environment against disaster, what kind of disaster is in prospect? A backward glance at history supplies various cases and kinds of environmental disaster. Industrial society has inflicted atmospheric pollutants on the air, producing high levels of smog, ozone and particulates in major cities like Los Angeles, Chicago, London, Tokyo, Bombay, Shanghai and St. Petersburg. Cities and towns have polluted water sources by allowing raw sewage to drain directly into them. Dumps and landfills have accumulated unsafe levels of toxins through careless disposal of waste products.

Pollution is not the only type of environmental damage. Land has been abused in myriad ways – through over-cultivation, over-grazing and over-fertilization. Aside from pollution, water has been overused and misused. It has also suffered damage at its sources. Although the process of evolution features extinction as an integral element, living species have been driven to or near extinction by human beings acting outside the boundaries of nature.

Americans have been schooled in the lore of these disasters. The extinction of the North American passenger pigeon in the 19th century, the near-extermination of the bison and the virtual disappearance of the wolf and the bald eagle are the staples of schoolbooks. Likewise the fate of the Dust Bowl in the 1930s and the problems of Southern farming prior to the development of crop rotation methods. Less well-known but no less telling are contemporary abuses resulting from Western cattle ranges and federal farm subsidies.

Virtually all of these examples are given a stylized narrative in which greed and capitalism are faulted. Heedless, bloated industrialists created pollution in order to fatten their profits while blackening the lungs of little children. Eastern meat-packers killed off the passenger pigeon. Rapacious buffalo hunters and their railroad bosses nearly did in the buffalo, ruining the civilization of the American Indian as a consequence. Farmers were too greedy; they should have settled for lower profits and planted fewer crops so as not to overwork the land.

The problem with these explanations is that they are morality tales rather than logical sequences. They provide no clue as to how disaster might have been avoided other than “make bad men with bad motives do good things instead.” The real story of past environmental disaster and prospective environmental policy incorporates the role played by markets and two key free-market institutions – property rights and prices. Disaster ensues when both of these are missing.

The Tragedy of the Commons

Ecologist Garrett Hardin is credited with enunciating the principle of the tragedy of the commons. Passenger pigeons and bison were not privately owned resources; they were a common resource, available to all at no nominal charge. Private owners would have realized that the cost of allowing animal numbers to dwindle below the reproduction point was prohibitive, but in a commons nobody takes that cost into account.

It is important to realize that the “tragedy” had nothing to do with morality per se and everything to do with the institutional framework in which consumption occurs. Pious, religious people; socialists; conservatives; libertarians – everybody behaves pretty much the same when faced with a commons. And they behave similarly in a free-market environment as well.

Property Rights and the Environment

A right to property is embedded in free-market economics and political philosophy. It dates to John Locke and Adam Smith and the founding fathers of the United States. In order to be effective, property rights must include not only ownership, but also the right to control the use and disposal of property. These guarantee that the rights holder has an incentive to protect and conserve the value of the property, which is a (potentially) valuable asset.

Americans have consumed vast annual quantities of beef for well over a century. Why did the comparatively modest demand for passenger pigeons suffice to eradicate them while cattle thrive despite the enormous demand for beef? Cattle are owned; their owners insure that breeding stock survive to reproduce the breeds and maintain the tremendous investment of the owners. Passenger pigeons had no owners; hunters had no practical option but to maximize their kill to get the most out of the limited supply while it lasted. Nobody derived specific benefit from preserving the species, so it vanished.

The bison were well on the way to a similar fate until the conservation movement – the precursor of environmentalism – stepped in, led by Teddy Roosevelt. The public sector barely managed to preserve a precarious survival for the bison until the private sector began commercially harvesting the animal, thus guaranteeing the survival of the species. The bald eagle and wolf were once threatened by hunters, not for their meat but to protect them from taking privately owned animals as prey. Their existence continues to be precarious despite their so-called “protected status” as “endangered species.” Why? Because they have no owners; nobody has a vested economic interest in their survival, only in their extermination. True, they have defenders who are emotionally committed to their well-being, but history and logic tell us that emotion is no substitute for economics.

The clinching argument for property rights as the key to environmental protection was made in Africa, not America. In 1990, economist Tyler Cowen noted that Africa had long struggled with the problem of elephant poaching by hunters. Because the African elephant was rapidly nearly extinction, hunting was banned on the continent. But ivory from elephant tusks was prized throughout Asia for various uses ranging from piano keys to billiard balls to aphrodisiacs. Poachers were willing to flout the law to get ivory for the lucrative black market, and African governments were reluctant to devote the substantial resources necessary to police vast land areas merely in order to save a small population of elephants whose value was merely symbolic and emotional.

In 1979, some African countries began allowing private ownership and commercial harvesting of elephants. Sure enough, elephant populations in countries allowing private property rights in elephants – Zimbabwe, Malawi, Namibia and Botswana – grew to robust levels. Owners had the motivation necessary to protect and breed their elephants. They also had the advantage of having to police only their own delimited property lines. Meanwhile, neighboring countries that did not allow private property rights – Kenya, Tanzania and Uganda, among others – saw continual declines. Kenya’s elephant population fell from 140,000 at the start of its hunting ban to 16,000 as of 1990. From 1970 to 1990, Tanzania’s population fell from 250,000 to 61,000; Uganda’s fell from 20,000 to 1,600.

Today, the principle is well-recognized in its application to ocean fisheries, which are threatened by depletion because they are mostly a public commons rather than protected by private ownership. Large areas of Africa feature barren terrain interspersed with healthy grasslands. The grasslands are privately owned; the barren spots are public lands that have been reduced to desert by over-grazing of nomadic herds. Public roads are the most familiar negative case of the commons and property rights at work, although they are seldom recognized as such. Because roads are publicly owned, nobody owns them. Everybody has an incentive to use them at will and without taking costs imposed on others into account. The inevitable result is rush-hour congestion and gridlock. An owner, though, would not allow that state of affairs to persist. That brings us to the other vital element of free-market environmentalism: prices.

A Price is Right

People react badly to the idea of private ownership because they believe that a private owner will somehow hoard or guard a resource “for themselves.” But it will very seldom be in the owner’s interest to prevent exploitation of a resource, simply because public demand will make it worthwhile to make it available. Because the resource has long-term value, the owner will want to use it only to the extent, and in such a way that, the long-term value is preserved. This notion is strikingly congruent with the idea of “conservation” that formed the original basis of the environmental movement.

Limitation of usage implies limitation of demand. The classic means to this end is charging a price for usage, which rewards the owner while signaling to the user that the resource is limited in quantity. Higher prices limit demand more effectively than lower prices; whether they are more rewarding to the owner technically depends on the price-elasticity of demand, or the responsiveness of buyer demand to changes in price when the other determinants of demand (income, tastes, prices of substitute and complementary goods) are unchanged.

Once again, people instinctively react against paying a price for goods and services. “Free” sound intuitively preferable. But free is only better in the very rare cases when the goods really were provided at no cost. Sunshine is truly a free good. Tangible goods and most services merit a price because this allows the buyer to compare the expected value received from consumption with the cost of production embodied in the price. (That cost of production will reflect the value of alternative output foregone in the production of the good under consideration.) Politicians who promise us free stuff are doing us no favor, since this merely wastes resources and ultimately gives us less stuff to enjoy.

Because resources in a commons are not owned, they typically do not command a price. Sometimes governments will try to remedy this deficiency by assigning a price of sorts to publicly owned goods, but this price does not reflect the true cost of production and the value of foregone alternative output because the government price is not the outcome of a competitive market. This kind of price – not prices charged by private owners – is the one of which the public should beware.

The failure to charge a (proper) price is the second major source of environmental disaster. For well over a century, municipalities have charged a flat fee for water usage. In effect, this levies an effective price of zero, since the flat fee does not change no matter how many times the consumer turns on the tap. (A true price is marginal, applying to each successive unit purchased.) Consequently, this encourages consumers to use water not only for drinking and bathing, but for washing dishes, cars and dozens of successively lower-valued uses. Meanwhile, the actual production of water requires resources for distribution and purification. Those resources have alternative uses that merit the application of a price tag on each successive unit of water consumed.

Various parts of the western United States, such as the Central Valley in California, would be unsuitable for agriculture without irrigation. The federal government has built dams, diverted streams and distributed water far below cost to farmers. This has enabled the production of crops that would otherwise not be produced. The future survival of the Colorado River, perhaps the key waterway in the southwestern U.S., is imperiled due to repeated impoundment of its waters for use by farmers and ranchers. Because the river is not owned, the farmers and ranchers do not pay a proper price for its use – and the river is on the road to extinction. Not only that, the land is being used in ways for which it is inherently unsuited. This is a classic tragedy of the commons and failure of pricing.

Good Guys and Bad Guys

The simplistic environmentalist tale reduces life to a cinematic conflict between good buys and bad guys, in which the outcome depends on the strength and purity of the participants. Today, American colonists and founders are cast as bad guys who despoiled the purity of the North American wilderness. American Indians are cast as the good guys, the “indigenous peoples” who lived in harmony with nature a la Rousseau. And American frontiersmen did indeed kill game and clear land without concern for the consequences of their actions on the supply.

But so did the Indians. The Plains Indians, for example, routinely migrated throughout a region, killing off buffalo and other game and freely polluting and despoiling land in their immediate vicinity. After all, they had no need to conserve natural resources when their numbers were so tiny in a vast natural preserve the size of North America. When local resources became scarce, they simply moved on. Then as now, economics was the prime mover, not philosophy or morality.

Air Pollution – the Special Case

The reader will have observed the absence of air pollution in the property rights and pricing examples discussed thus far. The logic previously developed explains that. Unlike animals, land and water, air is much less amenable to private ownership. (Nation states assert ownership to “air space,” so clearly the concept of owning air is not infeasible. The trick is to bring it within the private domain.)

Once more, it is tempting to treat the issue of air pollution as a morality tale. And once more, this temptation should be resisted. The world’s worst cases of air pollution are located within the borders of socialist or communist states, ostensibly dedicated to principles of social justice, public ownership and fair shares for all. Air is a classic commons, and the basic principles of property and pricing apply just as strongly to good guys as to bad guys. Indeed, in this context it would seem that the only good guys are those who strive to bring property rights and pricing to the public.

While the general public associates capitalism with pollution, the truth is just the opposite. The most capitalistic countries should be the least-polluting ones in theory and tend to be least-polluting in practice. This agrees with common sense (a quality in short supply among the general public). Capitalism operates under private property. Private owners don’t want to run down the value of their property or allow others to do so; thus, they are averse to pollution. Socialism implies public (i.e., government) ownership, which means the absence of incentive to protect property value and impede polluters. Passing laws to make government responsible does not actually make government responsible – as the old saying goes, who watches the watchers? Consequently, it is not surprising that Soviet Russia and Communist China were the champion polluters of the 20th century. In the U.S., the famous case of Love Canal was originated not by Hooker Chemical Co. but by the government to whom they sold their property, which actually polluted the canal.

The modern-day environmental movement is sometimes dated from the publication of Rachel Carson’s book Silent Spring in 1962. This is the point when the movement changed from emphasizing conservation to promoting a vague, indefinable concept of “the” environment as a holistic entity rather than a collection of heterogeneous elements. Prior to this, the strongest opponents of pollution were libertarian political philosophers like Murray Rothbard – the same people who were also the strongest defenders of free markets and capitalism. These libertarians took a per se approach to air pollution, forbidding it in principle as a violation of property rights.

More recent free-market environmentalist approaches take a different tack, noting that the economic approach is to compare the costs and benefits of any activity. If the benefits of steel production outweigh its costs – even when pollution costs are taken into account – then forbidding steel production in order to cut pollution to zero is too harsh. The idea should not be to ban pollution altogether – it should be to encourage efficient production in which the benefits of the produced output outweigh the costs of production including pollution. When regulating pollution, the emphasis should be on cost-effective pollution abatement. That is, we want to urge producers to find the best, least-costly ways to limit pollution.

In the past, governments have regulated industrial pollution by hiring experts to dictate the “right” ways to produce things, then requiring businesses to follow those rules. But the problem is that this “one-size fits all” approach is very inefficient. As F.A. Hayek noted, free markets are superior because they generate information about “the economics of particular time and place.” Each business should have the freedom to decide the best way to cut pollution based on its own particular circumstances and sources of expertise. Instead of telling businesses how to produce, government should simply tell businesses what outcome to achieve in terms of pollution reduction, and then leave the means of achieving that outcome to them.

Large Numbers and Small

For many years, economists believed that government regulation was the only way to handle all issues involving the environment. Because the existence of a commons entailed costs that a user would never take into account, so the argument went, the action of government was required to bring these costs into play. The cost was called an “externality” because it was external to the calculations of those participating in the non-governmental production and consumption of the good. Government would enter the picture by levying a tax on the good equal to the amount of the externality, thus “internalizing” it and forcing the user to take that cost into account in his or her consumption decisions.

In 1960, law-and-economics specialist Ronald Coase stunned the economics profession by pointing out that, in general, this approach was wrong. The problem was not an externality; the problem was the absence of property rights caused by the commons. The minute property rights are assigned, the rights holder has an incentive to internalize the externality without any interference by government. In fact, this solution is greatly preferred to government action since the property owner will probably know the costs involved while the odds are greatly against government knowing the correct size of the tax necessary or having an incentive to levy it even if it did know. This Coase Theorem eventually (and belatedly) earned Coase the Nobel Prize in economics.

Because the Coase solution will necessitate negotiation between property rights holder and counterparty (property owner and consumer, say), this still leaves air pollution as the hard case. The usual circumstances of industrial pollution involve very large numbers of third parties affected by the pollution. The business owner(s) will find it prohibitively costly to negotiate with each victim individually and the victims will find it too costly to organize in order to negotiate with the business owner. Thus, this “large numbers” case still leaves a role for government as regulator of air pollution.

Not Market Failure – Education Failure

The logic of free-market environmentalism is compelling – so much so that it extends beyond the environmental domain. Specialists in monetary and financial economics have pointed out that the federal government turned banking into a commons through federal insurance programs. The FSLIC and FDIC were ostensibly intended to reduce worry of S&L and bank failures by insuring deposits up to stated values. Unfortunately, this allowed owners of financial institutions to take investment risks beyond the norm because neither they nor the depositors were worried about the consequences – the taxpayers were the ones ultimately on the hook if the S&L or bank went bust due to bad investments. Thus, both the S&L crisis of the early 1980s and the financial crisis of the late 2000s were tragedies of the commons, analogous to the environmental disasters reviewed above.

In view of all this, why isn’t the logic of free-market environmentalism widely known and practiced? The only answer must be that the economics profession, whose members are disproportionately members of and supported by government, has done a deplorable job in educating the public about economics. If economists refuse to teach economics, who can we look to?