D’oh — The First in a Series or Carbon Tax vs Cap and Trade

I’m impressed at eating humble pie.  Steven Landsburg who blog on a wide variety of topics in economic does that here.  I have a few comments following.

Steven Landsburg | The Big Questions: Tackling the Problems of Philosophy with Ideas from Mathematics, Economics, and Physics

When something is wrong on the Internet, bloggers love to pounce. But since no blogger is infallible, most of us can find ample fodder in our own past writing, if we go back and reread it with a sufficiently critical eye. Over the next few weeks, I plan to revisit some things I got wrong the first time around. (You’ll recognize those posts by the Homer Simpson logo.) I hope others will be inspired to do the same.

To lead off this series: In December, 2009 I blogged about space scientiest James Hansen, who prefers carbon taxation to cap-and-trade. His argument: A carbon tax allows for the possibility of additional carbon abatements through altruism. Under cap-and-trade, if I altruistically decide to buy a fuel-efficient car, someone else gets to buy an SUV. Whereas under a carbon tax, if I altruistically decide to buy a fuel-efficient car, less gas gets consumed.

Wait a second, though. Under a carbon tax, if I decide to buy a fuel-efficient car, I drive the price of gas down, which encourages someone else to buy an SUV. So altruism is equally ineffective under either policy, no?

That’s the argument I made in December, 2009. I now believe that:

  • Under a plausible interpretation of Hansen’s argument, I was wrong.
  • But Hansen is still unconvincing, though for somewhat subtler reasons.

hansen1First, the key economic point. There is a demand curve for gasoline, and neither a carbon tax nor a cap-and-trade program can change that. The demand curve relates prices to quantities, and market forces will keep us on that demand curve. Government policies can move us along the curve but they can’t change the curve. Suppose we’re currently at the black point, and the government wants to move us to the red point. There are two ways to do that. You can have a cap-and-trade regime that moves the quantity to Q or a carbon tax that moves the price to P. Move either the quantity or the price and the other will follow.

In that sense, the two programs are entirely equivalent, as I said in my post. So far, Mr. Hansen has no reason to prefer one over the other.

hansen2Now let’s introduce some altruism. This moves the demand curve down, and changes the government’s menu of choices. Without the altruism, they can choose any point on the solid demand curve, and they can get to that point with either policy. with altruism, the same is true for the dashed demand curve. Still no reason to prefer one policy over another, which was the point of my 2009 post.

I realize, now, though, that Hansen (at least if we interpret him charitably, which is usually a good idea) was thinking about unexpected altruism, i.e. altruism that kicks in after the new policy is implemented. In that case, he’s right: If you fix the quantity at Q and then the demand curve shifts, the quantity stays at Q. But if you fix a tax rate that moves the quantity to Q on the original demand curve, and then the curve shifts, you will indeed move to a point on the dashed line where the quantity is less than Q. (I don’t claim to have proved that here, but those who have mastered Principles of Economics will be able to fill in the details.) So if Mr Hansen is concerned about changes in altruism that arise only after the policy is set, then he has a point.

What he seems unaware of is that his point cuts both ways. Whatever your current forecast of altruism, you are as likely to be wrong in one direction as the other. So a post-policy shift in demand is equally likely to be upward or downward. Hansen is right about this: If, after a gas tax is implemented, altruism rises, then gas consumption will fall further. But what he seems to overlook is this: If, after a gas tax is implemented, altruism falls, then gas consumption will rise. Either effect is avoided by cap-and-trade, and either effect is, as far as we know, equally likely. (Remember that we are attempting to forecast not altruism, but a change in altruism, which is much harder to get right.) So while Mr Hansen is not clearly wrong (as I incorrectly said he was), there’s still no particular reason to think he’s right.

via D’oh — The First in a Series.

One observation here is that this assume a fixed input output relation between carbon and gasoline.  That might not be true if the amount of carbon fuels in producing gasoline could be reduced.  The carbon in the gasoline maybe fixed by chemistry, but the amount of total carbon to produce I think is not.

I think this post makes a little broader point.

With a tax the quantity of reduction in the quantity sold is depending on the movement along and movement of the demand curve.  If the curve moves the quantity may be more or less than the target after the tax is imposed.  The quantity that is sold ultimately is unknown and not necessarily below the target, as desired.

A simple cap on amount sold would solve this problem.  The price will move to whatever clears the market at the chosen quantity.  The price could higher or lower than expected, but the target would be achieved.

The choice between the two would depend are we more concerned about uncertainty in the quantity that ultimately get sold, or the price of fuel.  If you value certainty with respect to price, cap and trade is preferred.  If you value certainty about the effect on the price of gasoline then the pigovian tax is the way to go.


3 responses to “D’oh — The First in a Series or Carbon Tax vs Cap and Trade

  1. Much here for we non-economists to ponder. Thanks.

  2. Pingback: Opinions in the Shorts: Vol. 95 « A Frank Angle

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