Political Economy Learn Essays

Political Economy

...uch of the damage from human activity is due to population growth exceeding the "carrying capacity" of the natural environment, how much is due to industrialization per se, and how much is due to serious flaws in our economic institutions that predictably lead to over exploitation and excessive pollution is hotly debated. I believe political economists who emphasize the environmental destruction that results from competitive market forces are on the mark, so I will concentrate on how markets and private enterprise contribute to environmental abuses, and what different approaches to environmental policy are likely to do about it. Markets and Environmental Destruction I'm the Lorax who speaks for the trees which you seem to be chopping as fast as you please. But I'm also in charge of the Brown Bar-ba-loots who played in the shade in their Bar-ba-loot suits and happily lived, eating Truffula Fruits. NOW... thanks to your hacking my trees to the ground, there's not enough Truffula Fruit to go 'round. And my poor Bar-ba-loots are all getting the crummies because they have gas, and no food, in their tummies! I, the Once-ler, felt sad, BUT... business is business! And business must grow regardless of crummies in tummies, you know. -- The Lorax, by Dr. Seuss -- There are four major reasons markets and private enterprise wreak havoc on the natural environment. (1) To a great extent the natural environment is a "common property resource," and when users motivated by individual concerns have free access, they predictably over exploit common property resources. Fisheries are examples of common property resources, or CPRs, often discussed by environmental economists. The problem for fisheries is that individual fishers have no reason to take into account: (1) the more fish they catch from a fishery the fewer fish others will catch for a given amount of effort this year, and (2) the more fish they catch this year the fewer fish will be available for all to catch next year. In other words, individual fishers have no incentive to consider the external costs their increased fishing imposes on other fishers this year and next. When every potential fisher ignores these external costs we predictably get over exploitation of the fishery. Over exploitation in the sense that the profits of this year's fishers will be less than they could have been had fewer fishers spent less time fishing. And over exploitation in the sense that the value of profits earned in the two years together could have been higher had fewer fish been caught this year so more could be caught next year. The figures are fictional, but the following example illustrates the problem of over exploitation of fisheries. There are 12 Salmon fishers with boats moored at Friday Harbor on San Juan Island, Washington State. It costs $100 per day in fuel and wages to run a salmon fishing boat and there are no other costs. The revenues from selling the salmon catch depend on the number of boats that go out each day according to the table below. Number of Fishing Boats 1 2 3 4 5 6 7 8 9 10 11 12 Total Revenues from Catch $200 $375 $525 $650 $750 $825 $875 $900 $900 $875 $825 $750 For simplicity we assume the price of Salmon is independent of the number caught, but as more and more boats go out to fish in the same school of salmon, they get in each other's way and the number of salmon caught per boat declines. 1) How many fishing boats will go out each day if all boats have free access -- that is, if there is nothing preventing a boat from going out if it's owner decides to? Answer: To answer this and other questions we complete the table by calculating additional columns. If every fisherman is equally equipped and competent, each would expect to catch the same amount as all the other fisherman fishing that day, and therefore expect to get the average revenue from the sale of the fish as his own expected revenue. We calculate the average revenue, AR, by dividing the total revenue, TR, by the number of boats fishing. What an individual profit maximizing fisherman would compare this expected revenue to would be the cost of fishing for the day, which is $100 for each and every boat no matter how many other boats are fishing. In other words, the marginal private cost, MPC, to a fishing boat captain of fishing for the day is $100, and as long as the average revenue of going out fishing is at least as high as the marginal cost of fishing, we would expect profit maximizing captains to go out if they have "free access" to the fishery. When trying to think like a captain, imagine you have picked up your crew in a truck, and when you get to the dock, you can count how many boats are still there, and therefore calculate how many have already gone out. For example, if you arrive and 6 boats are still in dock, that means that 6 have already gone out and if you go out there will be 7 boats fishing that day. Your decision is whether to go fish or walk back to the tavern with your crew and spend the day playing pool and telling fish stories. If you didn't go out, you don't have to pay for fuel and you owe your crew nothing. Number of Boats AR MPC MR TR 1 $200 $100 $200 $200 2 $187.50 $100 $175 $375 3 $175 $100 $150 $525 4 $162.50 $100 $125 $650 5 $150 $100 $100 $750 6 $137.50 $100 $75 $825 7 $125 $100 $50 $875 8 $112.50 $100 $25 $900 9 $100 $100 $0 $900 10 $87.50 $100 -$25 $875 11 $75 $100 -$50 $825 12 $62.50 $100 -$75 $750 The first captain will go out because he will expect to get $200 in revenues and spend only $100 in costs. The captain who comes down to the dock and sees 11 boats including his own will go out because he will expect to get $187.50 for his $100. What about the captain who sees 5 boats at the dock including his own? He will figure that 7 boats are out and he would be the eighth. With eight boats fishing he expects to get $112.50 for his $100 in costs. If the next captain thinks he is a little better than the average fisherman, he will go out too because the expected revenue if he were only average would be $100 which would pay for the $100 in costs. We say that the "equilibrium" number of boats to go fishing under free access is 9. The captain who arrives and sees only three boats left, including his own, will head straight for the tavern that day since he cannot expect to cover $100 in fuel and labor costs with $87.50 in revenues. The eleventh and twelfth late sleepers will turn around for the tavern even quicker. 2) How much does the last boat that goes out fishing under free access increase total revenues from the catch? In other words, what is the marginal revenue of the last fishing boat? Answer: The increase in total revenues from the 9th boat is $0 since 8 boats will catch $900 worth of fish just as 9 boats do! -- which illustrates the logic of over exploitation perfectly. If you have ever seen commercial fisherman racing each other to find the school of fish, and cutting in on each other once the school is located you will understand how at some point another boat does not increase the number of fish caught. This is true for grazing lands, timber harvesting, and oil pumped out of a reserve as well. Notice that the 9th boat went out because it was profitable for that fishing captain (who thought he was a little better than the average captain) even though the extra boat adds $100 in labor and fuel costs to the fishing effort while contributing nothing. 3) If the cost of operating a fishing boat dropped to $85 per day how many would go out? Answer: Now 10 boats would go out. 4) What would the marginal revenue of the last boat that went out be in this case? Answer: Notice how counter productive individual rationality is under free access. The tenth boat will go out because he expects (accurately) to get $87.50 while only spending $85. But by doing so he adds $100 to the overall cost of the fishing effort and REDUCES fish revenues by $25! Is there no remedy for this insanity? What if the 12 fishing boat captains formed a cooperative and successfully limited access to the common property resource? 5) Assuming again that operating costs are $100 per boat per day, if the 12 fishing boat owners formed a cooperative and agreed to pool all revenues and costs -- that is if each of the 12 boat owners paid 1/12 of the cost of operating how ever many boats were sent out and received 1/12 of the revenues from the total catch whether their boat went out fishing or not -- how many boats would the fisherman's organization send out each day? Under these circumstances the fishermen would want to maximize the difference between total revenues and total cost. But since sending out boats that add more to revenues than costs and not sending out boats that add more to costs than revenues is the way to maximize total revenues minus total costs, the fishermen would want to send out boats until the marginal revenue expected from another boat is no longer higher than the marginal cost of sending the boat out. That means that whereas we moved down the average revenue column until AR dropped to $100 -- which was the marginal private cost for each and every boat -- to see how many boats would go out under free access; we move down the marginal revenue column until MR drops to $100 to see how many boats the fishing cooperative would send out to maximize their profits, and therefore the profits of each fisherman, under self-restricted access. The fishing cooperative should send out no more than 5 boats since every boat after the fifth adds less than $100 to revenues but $100 to costs. 6) What would be the marginal revenue of the last boat the fisherman's organization sent out? Answer: $100 But now comes the 64 thousand dollar question: 7) Why might the fishing boat owners might fail to come to the agreement described in question #5? That is, why might the fishermen fail to organize a cooperative and restrict access from 9 to 5 boats per day? Answer: If you want to read some interesting case studies and insightful analysis of what factors make it more or less likely that groups will succeed in managing common property resources through restricted access, see chapters 1 and 3 of Elnor Ostrom, Governing the Commons (New York: Cambridge University Press, 1990.) In our example: actual and perceived equality between the fisherman in equipment, skill, experience, etc. makes less likely that some would refuse to join an organization that restricts access because they believe they can do better than average under free access. Also, if there are variations in catches, negotiating a deal where some fishermen get one tenth the profits and others get one fifteenth, for example, makes the bargaining more hassle prone. But most importantly, stability in the population of fishermen makes it easier to achieve and maintain restricted access. If a new, thirteenth fisherman can come along after the original 12 have agreed to limit the number of boats sent out to 5 per day and "ride for free" on the restriction of the others -- that is, fish every day himself enjoying the benefit of the other 12 only going out 5 days out of 12 -- it is harder to organize and maintain the coalition. Essentially, the fishing cooperative is a cartel. And as in all cartels there are incentives to cheat and free ride, and there are policing and punishment problems -- all of which might prevent those using CPRs from successfully agreeing to limit their access despite the fact that their profits would be higher could they do so. As a result, most CPRs are overexploited under free access. (2) Pollution is a "negative externality" of production or consumption activity. Since market economies predictably over produce goods and services whose production or consumption entails negative external effects, they also produce more pollution than is economically efficient. Last chapter we analyzed automobiles as an example of an industry where production and consumption entails negative external effects. We discovered that market forces lead to the production and consumption of more cars than is efficient, and therefore more pollution than is efficient as well, because market decision making ignores effects external to the car buyer and seller. But almost every industry is like the automobile industry to a greater or lesser extent. Cement factories emit particulates that cause urban air pollution as well as produce cement. Utility companies emit sulfur dioxide that causes acid rain while they produce electricity. And modern agriculture produces pesticide runoff contaminating ground water and rivers, as well as fruits and vegetables. The biosphere provides resources, assimilates wastes, provides amenities, and performs life support services. Whenever production or consumption diminishes the usefulness of the environment in any of these regards it is likely to go unaccounted for in a market system since most of those affected will be "third parties" whose interests will not be considered by the buyer or seller. Expecting a free market system not to pollute too much is like waiting for a lead balloon to float. But surely environmentally conscious people take the environmental effects of their actions into account. Isn't the answer more environmental education so we all become "Green consumers?" But now, says the Once-ler Now that you're here, the word of the Lorax seems perfectly clear. UNLESS someone like you cares a whole awful lot, nothing is gong to get better. It's not. We should consume so as not to pollute, and the environment certainly is better off because many who have become aware of the environmental consequences of their choices take those effects into account. But it is important to realize that a market system provides no incentives for people to engage in green consumerism. Quite the opposite, markets provide powerful incentives for consumers not to behave in environmentally responsible ways. To understand this, we need to consider the third major reason market economies destroy the environment. (3) Pollution reduction is a "public good," and due to the "free rider problem" and "transaction costs" market economies under produce public goods -- including pollution reduction. As we discovered in chapter 6 there is an incentive for everyone who benefits from a public good to try and avoid paying the cost of providing the good, and instead "ride for free" on others' purchases. When someone else buys a private good I do not benefit. But when others buy a public good I can benefit as much as they do. Since everyone benefits from pollution reduction, and none can be excluded from the benefits of pollution reduction, pollution reduction is a public good. And just like any public good, pollution reduction will be "under produced" in the context of market incentives. Clearing up the double negatives: The free rider problem among pollution victims in market economies leads to too much pollution. Everyone has an incentive to free ride when others practice "Green consumerism." Everyone has an incentive to under represent the degree to which they are adversely affected by the pollution for fear of receiving a high assessment in any coalition of pollution victims. For these reasons, victims of pollution cannot be relied on to successfully "ban together" and express their true demand for pollution reduction adequately and effectively in a market economy. Greenhouse gas emissions, deforestation, and the climate change that results illustrate the last two reasons markets are destroying the environment. Human economic activity over the past 100 years has lead to dramatic increases in atmospheric concentrations of carbon dioxide. Between 1860 and 1990 global carbon emissions rose from less than 200 million to almost 6 billion metric tons per year. At the same time, deforestation has reduced the recycling of carbon dioxide into oxygen considerably. The result of increased carbon emissions and reduced sequestration is that the stock of greenhouse gases in the atmosphere has increased to the point where it is leading to climate change with serious adverse affects. At its old equilibrium level the greenhouse effect was part of making the earth inhabitable -- preventing the earth's mean temperature from falling well below freezing and reducing temperature fluctuation between day and night. But higher levels of greenhouse gases in the atmosphere mean global temperatures will rise and extreme climate conditions will intensify. Droughts will be longer, floods more severe, hurricanes and tornados more frequent, and melting polar ice caps will raise sea levels and threaten a large percentage of the world's population who live in coastal cities. This is happening because businesses and households who burn fossil fuels are not charged for the adverse effect their actions have on the atmosphere -- carbon emissions are a negative externality. And it happens because owners of tropical forests are not paid for the beneficial effect of carbon sequestration if they choose to preserve them -- carbon sequestration is a positive externality. Markets lead us to engage in too much activities with negative external effects and too little activities with positive external effects. Hence, too much fossil fuel burning and too little forest preservation goes on under market incentives. Moreover, reductions in carbon emissions is a public good, as is preservation of forests that turn carbon dioxide back into oxygen. But since none can be excluded from benefiting from these public goods, and they do entail private sacrifices, all businesses, consumers, and nations will wait for someone else to shoulder the burden of providing the public good in hopes of riding for free on others' sacrifices. Every country wants to enjoy the benefits associated with carbon emitting activity and hope others will reduce their carbon emissions. It is not hard to see why international negotiations over greenhouse gas emissions get stuck since per capita emissions in 1990 were only .489 metric tons in poor countries but 3.426 in rich countries. Rich countries point to the unthinkable effects on the environment of poor countries following rich countries' industrialization path. While poor countries point to the inequity inherent in freezing emissions at present levels or demanding equal percentage reductions from all countries. And every country will continue to use their forests to best commercial advantage and hope other countries will refrain from deforestation and provide carbon sequestration services to all. Since users get paid for timber they cut, or cattle they raise after burning off tropical forests, but do not get paid for carbon dioxide sequestered, countries like Brazil, Zaire and Indonesia whose forests provide major sequestration services have no incentive to preserve them. In sum, the free market has given us global warming and provides no incentives for anyone to do anything about it. The last reason capitalist market economies despoil the environment is that market driven decisions over value the present and under value the future. (4) Decision making under the pressure of market competition leads to decisions based on a "rate of time discount" that is far higher than can be justified for social decision making purposes. Since timing is a critical consideration in the efficient use of the natural environment, this leads to predictable short-sightedness and over exploitation. When I decide how to weigh well being now versus well being next year, it is sensible for me to take into account the non-zero probability that I might be dead next year. What's more, there is a probability of one that I will be dead 100 years from now, so that whatever benefits might be made possible 100 years hence by my foregoing benefits today would presumably not matter to me at all. All of which implies that it is rational for a mortal being to discount well being in the future compared to well being now. On the other hand, there is a zero probability that there will not be human beings living next year. And while the probability that there will be no humans alive 100 years from now may not be zero, the probability is much less than one. So, unless we simply don't care as much about the well being of future generations as we do about our own, there would seem to be no justifiable reason for society to discount human well being in the future compared to human well being now when making decisions about how to use the natural environment. Or, so it appears at first. Since mortal human beings make decisions based on their individual interests under market conditions, it appears that the "rate of time discount" they will use when comparing present and future costs and benefits will be higher than the "rate of time discount" humans should use as a species that hopes to survive many generations. But it has been pointed out that this may not be the case. Suppose I own a mineral deposit that can be exploited this year or next year. If I know I will be alive both years and intend to exploit the deposit myself, I would be foolish to extract any ore this year that would be more valuable next year. But what if I don't expect to live past this year? Should I extract all the ore now since I won't be around to benefit from the profits from extraction next year? And does this mean that human mortality in conjunction with private ownership of natural assets must lead to over exploitation? Surprisingly, the answer is "no." Suppose I am only interested in how much I can get from the deposit this year before I die. Rather than pursue a less efficient one year extraction plan I should sell the deposit to someone who will be alive for two years for a price that reflects the profits that can be earned from the deposit under a more efficient, two year plan of exploitation. If I don't own the deposit but only have user's rights, I will be tempted to over exploit it myself before I die. But if I own the deposit and can sell it to someone who will live two years and make the most profitable use of it, then individual morality needn't lead to over exploitation. By extension, since users today know there will be people who will pay for the ore indefinitely into the future, the price of the asset should reflect its most valuable use over time, and whoever is the user should be forced to adopt the most socially useful pattern of exploitation in order to justify the price paid for the asset. Thus, mainstream economists argue that contrary to first appearances, when individuals own the natural environment as their private property, the rights of future generations are better protected than when decisions about how to use the environment are made through the political system. While the dead were known to vote in Cook County (Chicago) during the mayoral dynasty of Richard Daly Sr., the unborn have never voted in any political election. So if we rely on the political sphere to make decisions about the use of the natural environment, we must rely on the present generation to take the interests of future generations to heart. In other words, in the view of mainstream economists, we must rely on altruism rather than self-interest. To hear them tell it, unlike unborn voters, unborn consumers DO have votes in today's markets since today's users earn lower profits than they could have if they ignore tomorrow's dollar voters. So where is the problem? Why do decisions made in competitive market environments use a rate of time discount that is too high? Two reasons conspire to make the market rate of time discount significantly higher than a social rate of time discount that can be justified on ethical grounds: (1) future market failures, and (2) profit rates in excess of the growth rate of net welfare per capita. (1) Since uncertainty is cumulative over time, there is a greater degree of market failure in markets for goods and services delivered in the future, or what are called "futures" markets, than there is in markets for goods and services now, or what we might call "present" markets. For example, it is harder to find a market for oil delivered 25 years from now than it is a market for oil delivered this year, and if you do, the oil "futures" market is not likely to be as "well ordered." Futures markets tend to be "thinner" --- have fewer participants -- with wider, more unpredictable price fluctuations. But this greater degree of "market incompleteness" in futures markets means that on average, one is more likely to be paid the full benefit of a good or service delivered today than the full benefit that will come from delivery of the same good or service in the future. In other words, the greater degree of market failure in futures markets means market economies treat goods today as more valuable "birds in the hand," and goods in the future as less valuable "birds in the bush." (2) Contrary to our preliminary conclusion above -- that there unless we favor present over future generations the rate of time discount used for social decision making should be zero -- a reasonable case can be made for discounting future net economic benefits compared to present net economic benefits if net national welfare per capita is growing. If we interpret inter generational equity as equal opportunity to enjoy economic well being irrespective of generation, future well being should be discounted by the expected rate of growth in per capita economic well being. The idea is simple: if future generations are going to enjoy greater economic opportunities than we do, then the same amount of economic well being delivered now should count for more than if it is delivered later. But decision makers in private enterprise market economies are forced by competitive pressures to discount at a rate roughly equal to the normal rate of profit. And the normal rate of profit is significantly greater than the growth rate of Net National Welfare. So in capitalist economies future benefits are discounted more than they should be. Eban Goodstein defines Net National Welfare (NNW) as the value of "both market and non-market goods and services produced minus the depreciation of capital, both natural and human made used up in production, minus the total externality costs associated with these products" [i.e. the damage to the environment]. If NNW per capita is growing, then presumably the economic opportunities of future generations will be greater than the opportunities we enjoy today. At least in the first world, the per capita value of marketed goods and services produced minus depreciation of human made capital -- or what is called Net National Product (NNP) -- has grown over the past 200 years. Until recently apparently few economists noticed that the value of non-marketed goods and services was substantial, that natural capital was depreciating, and that harmful wastes were accumulating in the environment since it was common practice to use the growth rate of NNP as the social rate of time discount. But the value of the natural environment in both production and consumption has been reduced, particularly over the past 100 years. So using the growth rate of per capita NNP rather than NNW over discounts the future. There is some disagreement about how much NNP over estimates NNW, but the following studies are "in the mainstream." Nordhaus and Tobin estimated that per capita NNP had grown by 1.7% in the US from 1929 to 1965 while per capita NNW had only grown by 1.0% Daly and Cobb's estimates show a dramatic increase in the difference between NNP and NNW over the past 40 years in the US. For 1950-60 Daly and Cobb estimate that per capita NNP grew by 1% while per capita NNW grew by 0.8% For 1960-70 they estimate that per capita NNP grew by 2.6% while per capita NNW grew by 2.0% For 1970-80 they estimate that per capita NNP grew by 2.0% while per capita NNW fell by 0.1% And for 1980-86 they estimate that per capita NNP grew by 1.8% while per capita NNW fell by 1.3% Besides the alarming possibility that per capita NNW may now be falling, which implies that instead of discounting the future we should be discounting the present, average profit rates are two to three times as high as the growth rate of per capita NNP, and four to five times as high as any estimates of the growth rate of per capita NNW. The reason for this is simple: The rate of profit is determined not only by how fast NNP -- not NNW -- grows, but more importantly by how the net product is divided between employers and employees. The greater the bargaining power of employers versus employees the more the rate of profit will exceed the growth rate of NNP. This is easy to see by imagining a capitalist economy that is productive but not growing. An economy is "productive" if it is capable of replacing all the produced inputs it uses in production and still has a positive net product, or "surplus" left over. Unless the workers consume all of the net product some of the surplus will be left over for the capitalists. So unless the workers are all powerful and manage to keep all of the surplus, the ratio of the value of the net product left over for capitalists divided by the value of the goods capitalists advanced for the production process must be positive, and greater than the rate of growth of NNP which we stipulated by assumption to be zero. It can be shown: 1) there is a maximum rate of profit that corresponds to a wage rate of zero, 2) there is a maximum wage rate that gives workers the entire net product which corresponds to a profit rate of zero, and 3) between these two extremes the rate of profit is always positive and inversely related to the wage rate. But all real world capitalist economies must operate between the two extremes since workers would refuse to be workers in the first extreme and capitalists would refuse to be capitalists in the second extreme. So profit rates would always be positive in capitalist economies even if the growth rate were zero. Analogous theorems for a growing economy prove that normal rates of profit will always exceed growth rates. Since two of the most salient characteristics of the global economy over the past 15 years are the escalating degradation of the natural environment and the increasing power of capitalists visa vis workers on a world scale, the rate of growth of per capita NNW is declining and may have begun to fall, and the normal rate of profit is rising as we approach the end of the twentieth century. Consequently, the degree to which capitalist decisions over discount the future is increasing dramatically. Different Approaches to Environmental Policies We follow the lead of Michael Jacobs who identifies four different approaches to environmental protection. (1) Voluntary Mechanisms, (4) Government Expenditures, (3) Regulation, and (4) Financial Incentives. Voluntary Mechanisms: It is one thing to argue that voluntary mechanisms can have a positive impact on environmental regulation, and another to suggest that environmental protection should be left to voluntary mechanisms. There is no reason to deny the former, but every reason to reject the latter. "Green consumerism" like voluntary recycling and consumer boycotts of products packaged in styrofoam are not only important because they reduce pollution, but also because they play a critical role in developing people's environmental consciousness. On the other hand, we have already seen why the free rider incentive makes it individually irrational to engage in the socially efficient amount of "green consumerism." Nonetheless, opponents of government intervention insist that private initiatives can lead to the efficient amount of pollution. Even before Ronald Coase was awarded the Nobel Prize in 19??, the theorem bearing his name had become the major ideological bulwark against government intervention to protect the environment. Opponents of government intervention have cited this theorem to argue against government regulations on grounds that they are unnecessary and replace efficient private, voluntary initiatives with cumbersome, imperfectly informed, inefficient, bureaucratic, and coercive measures. Opponents of government intervention interpret the Coase theorem as "proving" that if property rights are clarified, voluntary negotiations between polluters and pollution victims will lead to the socially efficient, or optimum level of pollution. Although it may come as a surprise to many, a careful examination reveals that what Coase's theorem really explains is why private negotiations between polluters and pollution victims are not likely to lead to pollution reduction or efficient outcomes. What is striking about the "Coase theorem" is how many unrealistic assumptions are required to yield the conclusion that voluntary negotiations between polluters and pollution victims may lead to the efficient level of pollution. First of all, we must assume that there is a single polluter and a single victim of pollution. For if there are multiple victims, free rider problems mean the true preferences of pollution victims will not be accurately represented by a coalition of pollution victims. Second, we must assume there are no transaction costs to negotiations since there is no incentive to pursue efficiency gains smaller than the transaction costs of achieving them. Third, we must assume that both the polluter and pollution victim have perfect knowledge of the benefits and costs to the other party of any and all levels of production/pollution. In other words, the polluter must know just how damaged the pollution victim really is by different levels of pollution. And the victim must know just how profitable different levels of production/pollution are for the polluter. Otherwise negotiators have powerful incentives to mis-represent their true costs or benefits from pollution reduction in order to gain advantage in the negotiations. In particular it can be shown that the party with the property right to pollute (or be free from pollution) can increase their payoff greatly by misrepresenting their true costs or benefits. And when they do so, the outcomes that emerge from voluntary negotiations will be highly inefficient. Fourth, the distribution of the benefits from a successful "Coasian negotiation" must be roughly equal, since otherwise the party with least to gain from negotiations has no incentive to negotiate "in good faith." Finally, even if there is only a single victim of pollution, even if there are no transaction costs to negotiations, even if each party knows exactly what the other has to gain or loose, and even if the benefits of successful negotiations would be roughly equal -- a list of implausible assumptions that should daunt any reasonable analyst -- in the opinion of no less an authority than Nobel Laureate Kenneth Arrow there is no reason to believe negotiations between two parties unconstrained by competitive markets will achieve all mutually beneficial deals and thereby produce efficient outcomes. If negotiating "styles" are different there is every reason to believe that even under the most generous assumptions, a polluter and pollution victim may fail to negotiate an efficient outcome. To his credit, Ronald Coase himself recognized how seriously some of these assumptions limited the applicability of his theorem, particularly the assumptions of no multiple victims, no transaction costs, and perfect information. But his modern day disciples ignore their master's warning with the result that a theorem demonstrating the implausibility of voluntary negotiations yielding efficient levels of pollution is touted as a theorem proving that all will be well if we simply leave polluters and their victims to their own devices in a system of clearly defined property rights. Nothing could be farther from the truth, and Coase's theorem should help us understand why! Government Expenditures: Government expenditures are the least noticed environmental policy. But it may be that government expenditures on national parks and forests, water and sewage systems, transportation systems, and public utilities created because they were natural monopolies have a larger impact on the environment than either government regulations or financial incentives. The above kinds of government expenditures can have a great impact on the environment, for better or worse. For instance, when the federal government expanded the interstate highway system dramatically in the late 50s and early 60s it helped solidifying the dominance of automobile transportation -- with tremendous implications for land use (suburban sprawl) as well as smog and global warming. The negative effects of the interstate highway system probably outweigh the beneficial effects of gasoline taxes and EPA regulations on the lead content of gasoline. On the positive side, municipal expenditures on waste treatment is probably more beneficial to water quality than regulations regarding pesticide run-off. Radicals should not neglect to analyze the environmental effects of government expenditures because they are often quite important even when programs are enacted primarily for other purposes. Regulation: The dominant approach to environmental protection has been what detractors like to call "command and control," or CAC regulation. Sometimes this takes the form of requiring use of a particular technology such as catalytic converters in automobiles, or prohibiting the use of a particular technology, such as strip mining, or particular products such as DDT. In other cases, when regulatory authorities decide an overall reduction of a particular pollutant is necessary, the CAC approach is to require each and every individual polluter to reduce emissions by whatever percent regulators want to reduce overall emissions. The principal arguments against CAC regulations are: (1) they may not minimize the social cost necessary to achieve a particular level of overall reduction, and (2) they offer no incentive for firms to develop new technologies that could reduce emissions by more than the amount mandated. These objections are strongest when it is possible to develop new technologies that are "cleaner" than mandates require and when there are significant differences between the costs of pollution reduction for different polluters. For example, if one of two polluters can reduce emissions for half the cost of the other, it is inefficient to have the polluter for whom pollution reduction costs are higher reduce emissions by the same percentage that the polluter with lower pollution reduction costs does. In this case, equal percentage reductions are achieved at a higher overall cost than if the polluter who can reduce emissions more cheaply cut back by a larger percentage than the polluter for whom reductions are more costly. There is no denying the fact that when pollution reduction costs differ among polluters, CAC regulations that require equal percentage reductions for all polluters fail to minimize the overall cost of achieving a given reduction in overall pollution. But the degree to which CAC regulations are inefficient depends on the degree to which different polluters face different reduction costs. Where reduction costs are similar, CAC regulations are almost as efficient as alternatives such as pollution taxes and tradable pollution permits, and may have significant ideological and political advantages. Radical economists needn't be ashamed to support a CAC approach in many real world situations, and should hesitate to criticize environmental groups who favor this approach for economic naivete. Financial Incentives: The policy instrument favored by most mainstream economists, and particularly popular in light of the ongoing, world wide, ideological free market jubilee, are financial incentives, or what market advocates like to call "market based solutions." The newest tool in this box is tradeable pollution permits. The old version of financial incentives is pollution taxes. How does each work? What are their similarities and differences? And why does the corporate community prefer marketable permits to pollution taxes? Pollution Taxes: The logic of pollution taxes is to make producers take into account the cost to society of their pollution just like they have to take into account the cost of using scarce labor and raw materials. The market makes them pay for the labor and raw materials they use, but unless the government levies a pollution tax producers don't have to pay for their pollution. Consequently producers ignore this social cost when maximizing their private profits. The pollution tax seeks to "internalize" the otherwise "external" and neglected effect. When all polluters pay the same tax per unit of emission those with lower pollution reduction costs will find it in their interest to reduce emissions more than those with higher pollution reduction costs. This means that unlike mandated reductions, pollution taxes distribute pollution reduction among polluters in a way that minimizes the cost of achieving any level of reduction. Moreover, all polluters have an incentive to look for cleaner technologies since this lowers their pollution tax bill. Better still, pollution taxes make the polluter pay and imply that the polluter does not have a right to pollute unless he pays for the damages he inflicts on others. But this doesn't mean that pollution victims are compensated to the degree they are damaged. If pollution does not fall evenly on all citizens, or if citizens are damaged to different degrees by the same amount of pollution, then pollution taxes that reduce everyone's personal taxes to the same extent do not compensate individuals in proportion to damage. More importantly, there is no natural mechanism in a market economy to determine how much damage pollution causes. The market generates no quantitative estimate of how great the cost to society is of a unit of a pollutant. Therefore, there is no way to know how high the pollution tax should be set. If it is set too low, producers will pollute too much. If it is set too high, they may pollute too little. The latter possibility sounds nonsensical to most serious environmentalists. But as economists we know that pollution accompanies production of goods that are presumably valuable. So a pollution tax higher than the true social cost of pollution would lead producers of the good (and pollution) to produce less of the good than is socially efficient. But as radicals we should also know that this error almost never occurs. Governments almost never set pollution taxes higher than the social cost of the pollution because they are constantly under political pressure from the business community to minimize pollution taxes -- not because this error is a logical impossibility. In market economies authorities have to resort to non-market methods like surveying pollution victims to determine how high the social cost of pollution is. Authorities have to ask victims how much they would be willing to pay for pollution reduction, or how much victims would insist on being paid to permit further pollution. Unfortunately, these "willingness to pay" and "willingness to accept damages" surveys are often contradictory, leading economists to question their findings. Willingness to accept damage studies commonly estimate social costs four to ten times as great as willingness to pay studies although they should come up with roughly the same estimate. For this reason developing more reliable and less biased methods for conducting contingent valuation studies is one of the most important tasks that falls to radical economists. Only contingent valuation methods have any possibility of measuring the option value and existence value of environmental assets along with their use value. And only contingent valuation studies can possibly eliminate income biases by asking what percentage of their income people would be willing to pay rather than how many dollars they would be willing to pay. The major alternative, hedonic regression excludes option and existence value entirely leading to significant under evaluations of environmental assets and weighs the preferences of wealthier citizens more heavily than those with fewer dollar votes. But besides designing and conducting CV surveys that incorporate option and existence value and eliminate income biases, improving techniques to reduce discrepancies is crucial. Unfortunately for pollution victims, skepticism about the reliability of CV results makes it easier for polluting businesses to lobby successfully to keep pollution taxes way below the true social costs of pollution. Tradable Pollution Permits: The very idea of tradable pollution permits is an outrage to most serious environmental activists. Yet mainstream environmental groups like the Environmental Defense Fund have embraced this relatively new policy instrument as the center piece of their strategy for saving the environment in today's capitalist world. And even some "militant" environmental activists prefer tradable permits to pollution taxes. The policy is simple. If anyone emits x units of a pollutant, they must own x permits for that pollutant. Emissions in excess of the number of permits owned is a violation of the law just like driving without a driving license, and subject to whatever punishment is established. In many respects tradable pollution permits lead polluters to behave in the same way that pollution taxes do. If I want to pollute more I have to have more permits. If I don't own enough permits, I have to buy more on the "pollution permit market" -- which is costly. But even if I own enough permits to pollute as much as I want, it is costly for me to pollute because the more I pollute the fewer permits I can sell for a profit on the permit market. Either way there is an "opportunity cost" to polluting more. And if the price of a pollution permit is the same as a pollution tax, the opportunity cost of polluting more is the same in both cases. Once this is recognized, it is easy to see why supporters argue that pollution permits yield the same efficiency advantages as pollution taxes. There is always an incentive to develop cleaner technologies because the business would have to buy fewer (or be able to sell more) pollution permits. And firms with low costs of pollution reduction will reduce more than firms with high costs of pollution reduction since the former will find it cheaper to reduce emissions and avoid having to buy as many permits (or be able to sell more permits) while the latter will find it cheaper to continue polluting and paying for the extra permits (or selling fewer excess permits.) As a matter of fact, there is one version of tradable permits that yields exactly the same results as a pollution tax. Suppose the regulatory authorities decide they want a 20% reduction in a certain pollutant. They can charge a pollution tax of $X per unit and see if overall pollution drops by more or less than 20%. If it drops by less, they can raise the tax until a 20% reduction is reached. If a tax of $X lowers pollution by more than 20% they can lower the tax until 20% is reached. By trial and error the authorities can achieve a 20% pollution reduction. Suppose the tax that yields a 20% reduction is $Y. Alternatively, the authorities can print up pollution permits for 80% of the number of units of pollution that had been emitted and sell these permits at a public auction. If there are no problems with market "thinness" or market power, permits will end up selling for $Y at the auction; the public authorities will collect the same amount of money selling the permits as they collect in pollution taxes; each polluter will pay as much for pollution permits as they pay in pollution taxes; each polluter will reduce emissions by exactly the amount they do under a pollution tax of $Y -- low cost pollution reducers reducing more than high cost pollution reducers; and, of course, we have the same level of overall reduction, 20%, since we only sell permits to pollute 80% of previous levels. Amazing! So what's the big deal? Why do serious environmental activists hate pollution permits compared to pollution taxes? And why do polluting businesses love pollution permits and hate pollution taxes? One reason is that while marketable permits COULD be auctioned off at "pollution tax" prices, they won't be. Instead they will largely be given out free to those who have polluted in the past. As a matter of fact, the most common approach to distributing pollution permits known as "grandfathering" is to award permits according to how much a business polluted in the past. For example, if regulatory authorities wanted a 20% reduction in emissions they would issue every polluter enough permits to cover 80% of the pollution they emitted last year. Under this formula, not only would polluters pay nothing, and taxpaying pollution victims receive no relief (all permits are awarded free), but the biggest offenders would get the most permits and they could re-sell any they didn't use at a profit to boot! Another reason is that while the number of permits issued COULD be sufficiently low to achieve significant pollution reduction -- ideally reducing pollution up to the point where the marginal social cost of further reduction is higher than the marginal social benefit -- it won't be. Even if permits are issued free of charge, requiring polluters to own permits will raise production costs above pre-permit levels. Therefore, the business community will lobby for free permits over pollution taxes, but just as they press for the lowest pollution taxes, they will lobby for the smallest amount of pollution reduction, or the largest number of pollution permits. So there is no reason to believe that reductions approaching social efficiency will be obtained through tradable pollution permit programs. And market thinness and market power are real world problems. It is easy enough for economic theoreticians to assume away market thinness and market power and deduce that permits could yield the same outcomes as pollution taxes. But it is not so easy to eliminate these problems in real world markets. So compared to pollution taxes, tradable pollution permits have serious technical disadvantages whenever these convenient assumptions are unwarranted since the effectiveness and efficiency of pollution taxes is unaffected by non-ideal market conditions. But the most important reason environmental activists and the business community react so differently is that acceptance of tradable pollution permits concedes the fundamental ideological and political principal that businesses have the right to buy and sell our health, our natural environment, and the environmental legacy of our children and grandchildren -- all for their private ends. What Thorstein Veblen called "the business system" has penetrated ever more aspects of human life over the past 500 years -- making our laboring capacities and more and more of our social relations into commodities to be bought and sold. Tradable pollution permits say loud and clear that we accept commodification of the last areas that had escaped commodification if not exploitation. Tradable pollution permits mean that care of the delicate web of life we call the natural environment -- that human beings have the power to preserve or destroy -- is now to be turned over to the logic of the business system which will auction off the air, water, and any previously undomesticated species to the highest bidder. And this IS what things have come to at the close of the twentieth century. So why does the Environmental Defense Fund think environmentalists should push pollution permits instead of pollution taxes? Probably because they want to placate the strongest opponents of pollution reduction -- the business community -- at the expense of a constituency that seems particularly unable to defend itself -- the average tax payer -- reasoning that they can get more pollution reduction via this opportunist strategy than any other, for now. Besides, this way they can jump on the free market ideological bandwagon rather than tackle the hard job of derailing the market juggernaut ultimately responsible for environmental destruction. The problem with this opportunist strategy is that the stronger partner in most alliances usually succeeds in "using" the weaker partner more than visa versa. Some considered militants in the environmental movement whose solution to deforestation is to buy tropical rain forests in the Third World and deny access to all, have also been seduced by tradable pollution permits. They reason that after they have used their limited political power to lobby the government to issue few permits, they can use their private wealth to steal additional pollution reduction by buying permits on the free market and then burning them, thereby achieving even greater levels of pollution reduction. While this strategy has obvious appeal to us former draft card burners, it is difficult to sustain victories beyond one's political power. There is nothing to keep businesses adversely affected by the disappearance of pollution permits from successfully lobbying governments to issue more permits. After all, employment and economic prosperity cannot be sacrificed by allowing a few wealthy eco-terrorists to take advantage of a technicality and destroy tradable pollution permits after buying them. And acceptance of the legitimacy of pollution permits implicitly accepts economic growth as the ultimate goal. The following problem illustrates the similarities and differences between regulation, pollution taxes, and tradable pollution permits, and demonstrates why polluting companies, pollution victims, and taxpayers have different interests in how the government approaches pollution reduction. It suggests that pollution taxes are always a first best policy on efficiency grounds, and always in the best interests of pollution victims and taxpayers as well. As long as private enterprise and markets are with us it appears that progressives have every reason to favor pollution taxes over other policy alternatives on equity and efficiency grounds. No wonder it has become the forgotten environmental policy of the 1990's! Environmental Policy in Sniffleville There are 1 million residents in Sniffleville and 3 steel companies producing steel and air pollution. The steel companies are from different eras and therefore use significantly different technologies. The marginal costs of pollution reduction for the three firms are: Old Reliable Steel: MC = 500 - 3X(1) (in millions of dollars) Golden Age Steel: MC = 400 - 2X(2) (in millions of dollars) New Wave Steel: MC = 200 - X(3) (in millions of dollars) Where X(1) is the number of tons of snifflette pollution released by Old Reliable per year, X(2) is the number of tons of snifflette released by Golden Age per year, and X(3) is the number of tons of snifflette released by New Wave per year. The equations reflect an important characteristic of pollution reduction: When a firm has already reduced pollution considerably, the cost of further reductions is usually higher. Firms exhaust the low cost ways to reduce pollution first, therefore the more tons of pollution being released, the lower the marginal cost of reduction -- hence the negative signs before the "X" terms in the equations. Currently Old Reliable is emitting 500 tons, Golden Age is emitting 300 tons, and New Wave is emitting 200 tons of snifflette. The Sniffleville City Council commissioned a study by a distinguished group of environmental economists at the American University who did a "willingness to pay," or WTP study to estimate how much residents were willing to pay for reductions in snifflette pollution. The environmental economists simply asked a random sample of 1000 residents in Sniffleville how much they would be willing to pay for reductions in snifflette pollution. They asked respondents to consider both health consequences and inconvenience or discomfort as well as any other considerations that mattered to them, but provided no further information. Surprisingly, and conveniently, while respondents gave different answers about how much they would be willing to pay for snifflette pollution reduction, they all said they would pay the same amount for a one ton reduction no matter how many tons were being emitted [or how many tons had already been reduced.] The average willingness to pay for reductions in snifflette emissions per year by the 1000 respondents to the survey was $10 per ton. Assume you believe that the Environmental Economists' Willingness to Pay Study provides an accurate estimate of the social benefits to residents of Sniffleville of snifflette pollution reduction. 1) How high should the Town Council set a pollution tax? That is, how much should steel companies be charged per ton of snifflette they emit? Answer: The social benefit of reducing pollution by 1 ton is $10 per resident times 1 million residents = $10 million per ton. Therefore, to incorporate the full external cost, the pollution tax should be set at $10 million per ton. Any lower tax will lead to more pollution than is socially optimal, i.e., the MSC of further reductions would still be less than the MSB of further reductions. Any higher tax will lead to less pollution than is socially optimal, i.e., the MSC of the most recent reductions was greater than the MSB from the most recent reductions. 2) How many tons of pollution will each steel company emit under this socially optimal pollution tax? Answer: As long as the marginal cost of reduction is less than $10 million each company will reduce emissions rather than pay the $10 million tax. But as soon as the marginal cost of reducing another ton is greater than $10 million it is cheaper for the company to continue to emit snifflette and pay the tax. So a company will continue to emit snifflette until the marginal cost of reduction, MC, is equal to $10 million, and we can set MC equal to $10 million in the above equations and solve for the number of tons of emission that yield this level of reduction costs for each company: OR: MC = 500 - 3X(1) = 10; X(1) = 163.33 tons BA: MC = 400 - 2X(1) = 10; X(2) = 195 tons NW: MC = 200 - X(3) = 10; X(3) = 190 tons 3) If the Town Council is going to issue tradable pollution permits, how many permits should they issue if a permit allows the owner to emit one ton of snifflette? Answer: The Town Council should issue 163 + 195 + 190 = 548 permits where each permit allows the owner to pollute 1 ton per year. We know this because when polluters were forced to "internalize" the external cost they imposed on the citizenry -- $10 million per ton -- they only emitted a total of 548 tons. So this is the "efficient level of pollution" which the town council can secure through a permit program by issuing exactly 548 permits. 4) If the Town Council auctioned off the number of tradable permits you calculated they should issue in the previous question, what price should they end up selling for? [Ignore market thinness and market power and calculate the "equilibrium" permit price.] Answer: If they auction off 548 permits the equilibrium price per permit will be $10 million per permit. We know from the answer to question #2 that if polluters are forced to pay $10 per ton of emissions they will "demand" to pollute 548 tons. If the town council creates a supply of 548 permits, then at $10 million per permit the demand will exactly equal the supply of permits, which means $10 million is the equilibrium price of permits if the supply is 548. 5) But the Town Council cannot find out how many permits to issue to achieve the "efficient" level of pollution by setting the marginal cost of reduction equations for the three companies equal to $10 million and solving for the optimal level of pollution as we just did. Presumably each steel company knows its marginal cost of pollution reduction equation, but the companies will keep this a closely guarded secret. And if the town council were naive enough to asked the companies for this information, the companies would have every incentive to lie -- pretending their pollution reduction costs are much greater than they really are -- so the town council would issue more than the optimal number of permits and the companies could buy permits for a lower price than otherwise. Which leaves the intriguing question: Is there any way for the Town Council to find out how many permits they should issue since the steel companies are not likely to provide accurate information on their pollution reduction costs to the Town Council? Answer: The dilemma is: The town council has no information on the reduction costs of the different firms. They don't have the above equations so they can't calculate 163, 195, and 190 to get 548, as you did in questions #2 and #3. And if the Council asked the steel companies for the information, the companies would lie and over represent their reduction costs. So how can the Town Council get around this dilemma? Simple "trial and error." All they have to do is guess a number of permits and adjust the number upward if the permits sell for more than $10 million per permit at the auction, and downward if the permits sell for less than $10 million. Say they issue 750 permits. The selling price will end up lower than $10 million per permit signalling the Town Council they issued too many. If they sell 500 the selling price will end up higher than $10 million, signalling they issued too few. All they have to do is keep adjusting the number of permits they auction off until the selling price is $10 million. They never have to have the reduction cost information that the companies have and would lie about if the Town Council tried to get it from them. But notice, the Town Council can only use trial and error if it knows what permit price it is "aiming for!" And this will only be the case if they have a contingent valuation study -- in this case the WTP survey -- to give them an estimate of the magnitude of the external cost of pollution. With no quantitative estimate of the external cost the Town Council would have no way of determining how many permits to issue. They would be shooting in the dark. 6) If the Town Council gave away one third of the permits issued to each steel company, free, what price will permits sell for if they were tradable? [Ignore market thinness and market power.] Answer: Still $10 million since overall supply and demand in the permit market would be exactly as before. 7) If the Town Council used the "grandfather" system of awarding permits free of charge, how many would they give to each steel company? Answer: OR: 500/1000 or 50% of 548 = 274 BA: 300/1000 or 30% of 548 = 164.4 NW: 200/1000 or 20% of 548 = 109.6 8) What price will permits sell for if they were tradable under the grandfather system described in the previous question? Answer: Still $10 million for the same reason: If the supply of permits is 548 there will be excess demand at any price lower than $10 million -- driving the price up -- and excess supply at any price higher than $10 million -- driving the price down. 9) Suppose the Town Council opted for a "Command And Control" or CAC program instead of either a pollution tax or tradable permit program. If they ordered all three steel companies to reduce emissions by 45.2% which companies would have to reduce emissions by more than under the financial incentive policies and which less? A 45.2% reduction is an "equivalent" regulatory policy to a pollution tax of $10 million or a tradable permit policy with 548 permits since all three yield the same total pollution emissions -- 548 tons. But notice there is no way for the Sniffleville Town Council to know what the optimal reduction percentage would be. Without a CV survey there is no way to know the level of the optimal pollution tax or the optimal level of permits to create. But even with a CV survey there is no way for the City Council to figure out that a 45.2% reduction order is optimal rather than a smaller or larger reduction mandate. Only if they first used the CV information to implement a pollution tax or permit policy and thereby discovered that 548 tons was the optimal level pollution level could they discover that a 45.2% reduction was optimal. For all the criticism mainstream economics have fired at CAC policies on efficiency grounds, it is astounding that this liability goes almost entirely unmentioned. Perhaps the reason lies in not wanting to admit that no policy can lay claim to achieving the efficient level of pollution -- where the MSC of further reductions equals the MSB of further reductions -- unless there is a non-market based estimate of the MSB from some sort of survey. Answer: Under this CAC each company would continue to emit 54.8% of their original emissions: OR: 54.8% of 500 = 274 which is > 163.33 GA: 54.8% of 300 = 164.4 which is < 195 NW: 54.8% of 200 = 109.6 which is < 190 So OR would pollute more under CAC than financial policies, and GA and NW would pollute less under CAC than financial policies. 10) Which policy -- pollution tax, auctioned tradable permits, equal distribution of tradable permits free of charge, grandfather distribution of tradable permits free of charge, or CAC -- is best for the Sniffleville tax payer? Answer: The Sniffleville tax payer is best off under a pollution tax or an auctioned tradable permit policy since under both these options the government collects 548 times $10 million or $5480 million from the steel companies, permitting a reduction in personal taxes by the same amount. 11) Which policy -- pollution tax, auctioned tradable permits, equal distribution of tradable permits free of charge, grandfather distribution of tradable permits free of charge, or CAC -- is best for stockholders in New Wave Steel Company? Answer: NW is best off under a system of free distribution of permits with each company getting one third of the 548 permits issued. They are better off under free permit distribution than buying them at an auction. And they get more free permits under the policy of every company getting the same amount [33% of 548] than under the grandfather system [20% of 548]. 12) Which policy -- pollution tax, auctioned tradable permits, equal distribution of tradable permits free of charge, grandfather distribution of tradable permits free of charge, or CAC -- is best for pollution victims in Sniffleville? Will all residents be equally benefited? Answer: As long as Snifflette is a uniform pollutant, the only thing that matters to the pollution victims is how many tons of pollution are emitted in total. Since total emissions are 548 tons under all the policies considered, they are equally well off under any and all options -- except for no policy at all since that leads to 1000 tons of emissions. [If snifflette were not a uniform pollutant residents closest to OR are better off under a tax or permit policy since OR will emit 163.33 tons under those policies but 274 tons under CAC. Residents closer to GA or NW would be better off under a CAC policy since 164.4 < 195 (GA) and 109.6 < 190 (NW.)] But even if snifflette is a uniform pollutant, this does not mean that every resident is made better off to the same degree by reducing emissions from 1000 to 548 tons. The asthmatic, young, weak, and sick presumably benefit more than the strong and healthy. And those with a higher preference for clean air benefit more than those who don't care as much about air quality. Lecture Five MACROECONOMICS: AGGREGATE DEMAND AS LEADING LADY Keynes' "macro law of supply and demand" helps explain unemployment and inflation as well as the logic of government fiscal policies used to combat them. Armed with facts rather than myths about debt, deficits, and inflation, we can unravel what is really at stake in the drive to balance the budget. Before the Great Depression of the 1930s there was only "economic theory." Thanks to the Great Depression and John Maynard Keynes we now have "microeconomics" and "macroeconomics." Economic theory bifurcated because some in the mainstream of the profession finally recognized that standard economic theory shed no light on either the cause or cure for the Great Depression. The old theory was relabeled "microeconomics" and preserved as the center piece of the traditional paradigm, and a new theory called macroeconomics was created to explain the origins of, and remedies for unemployment and inflation. The leading lady in Keynes' new drama was aggregate demand, that is, demand for all goods and services in general. And Keynes' macroeconomics has proved remarkably helpful for understanding certain kinds of unemployment and inflation, as well as the effects of government fiscal and monetary policy. Macroeconomics can be understood using one new economic "law," one economic "truism," and simple theories of household consumption behavior and business investment behavior. The Macro "Law" of Supply and Demand The new "law" is the macro law of supply and demand. It is the macroeconomic analogue of the micro law of supply and demand which is the key to understanding how markets for particular goods and services work. The macro law of supply and demand is the key to understanding how much goods and services the economy will produce -- whether we will produce up to our potential employing all available economic resources fully, or we will produce less than we are capable of because not all labor and resources are used. It is also the key to understanding whether or not we will have inflation because the demand for goods and services in general exceeds the supply of goods and services the business sector is capable of producing so that excess demand "pulls" up the prices of all goods and services. The macro law of supply and demand says: aggregate supply will follow aggregate demand if it can. Aggregate supply is simply the supply, or amount of final goods and services produced as a whole, or in the aggregate. It includes all the shirts and shoes produced, all the drill presses and conveyor belts produced, and all the MX missiles and swing sets for parks produced. Aggregate demand is the demand for final goods and services as a whole. It includes the demand from all the households for shirts and shoes, the demand from all the businesses for drill presses and conveyor belts, and the demand from every level of government for MX missiles and swings sets for parks. The rationale behind the macro law of supply and demand is as follows: The business sector is not clairvoyant and cannot know in advance what the demand will be for their products. Of course individual businesses spend considerable time, energy, and money trying to estimate what the demand for their good will be, but in the end they produce what amounts to their best guess of what they will be able to sell. In other words, the business sector as a whole produces as much as they think they will be able to sell at prices they find acceptable. They don't produce more because they wouldn't want to produce goods and services they don't expect to be able to sell. And they don't produce less because this would mean foregoing possible profits. What if they prove too pessimistic? That is, what will happen if the business sector produces less than it turns out they are able to sell? This does not mean that every business, or every industry is producing less than it can sell. No doubt some businesses, and maybe even entire industries will have over estimated the demand for their product. But what if, on average, or as a whole, businesses under estimate what they will be able to sell? They will discover their error soon enough because sales rates will be higher than production rates. If we imagine businesses producing goods, depositing them in warehouses, and then selling out of their warehouses, most businesses will discover that their warehouse inventories are being depleted because sales are outstripping production rates. The macro law of supply and demand -- which like the micro law of supply and demand, and the law of supply, and the law of demand before it are interpreted as the usual results of sensible choices people make in particular circumstances, rather than like the law of gravity that applies exactly to every mass in the presence of every gravitational force -- derives from the common sense observation that, on average, when businesses find their inventories being depleted because sales are outstripping production they will increase production rates if they can. Because if this is what most businesses do, even if they initially underestimate the demand for their products, they will end by increasing production when they discover their error and therefore aggregate production or supply will rise to meet aggregate demand. Or at least, this is what businesses will try to do. But there might be circumstances under which they won't be able to increase production. What if all the productive resources in the economy are already fully and efficiently employed? In this case the increased labor and resources necessary for one business to increase its production would have to come from some other business where they were already employed, so the increased production of one business would be matched by a decrease in the production of some other business and production as a whole, or aggregate supply could not increase. This is why the macro law of supply and demand says that aggregate supply will follow aggregate demand if it can. Because if the economy is already producing the most it can, if it is already producing what we call potential, or full employment gross domestic product, aggregate supply will not be able to follow aggregate demand should the aggregate demand for goods and services exceed potential GDP. But sometimes the business community is overly optimistic. When they individually produce what they expect to be able to sell we find that the combined result, or aggregate supply, exceeds the aggregate demand for goods and services. What will happen in that case? On average businesses will find they are selling less from their warehouse inventories than they are producing and adding to those inventories each month. While a business may decide this is a temporary aberration and continue at current levels of production for a time, if the situation persists most businesses will eventually cut back on production rates. When that occurs the supply of goods and services in the aggregate will fall to meet the lower level of aggregate demand, so to speak. So this is the other way in which aggregate supply will follow aggregate demand. Notice how this simple, common sense law provides powerful insights about what level of production an economy will settle on, and whether or not the labor, resources, and productive capacities of the economy will or will not be fully utilized. And notice how the answer to the question: "How much will we produce?" Is not necessarily: "As much as we can." If the demand for goods and services in the aggregate is equal to potential GDP then when aggregate supply follows aggregate demand we will indeed produce up to our capacities. But if aggregate demand is less than potential GDP, then when aggregate supply follows aggregate demand, production will be less than the amount we could have produced, and consequently, there will be unemployed labor and resources and idle productive capacity. This does not happen because the business community wants to produce less than it can. It is because it is not in their interests to produce more than they can sell. And while it is true that the owners of the businesses in a capitalist economy are the ones who get to decide how much we will produce, there is no point in blaming them for lack of economic patriotism when they decide to produce less than w