12.1: Incentives and the Source of Cost-Effectiveness

Understanding cost-effectiveness requires first that we understand the concept of an externality. The fundamental source of the climate problem in a market economy comes down to the idea of external cost. When you buy something in the market, you are paying for the labor, materials, capital, and technology that lie behind the final product. If in the process of making the product, or in the process of your using it, other people get hurt, an externality is created. The word comes from the idea that the damage is outside or “external to” the people buying and selling the product. For example, the tremendous damage that will be done to future generations as a result of climate change is external to the goals of many companies (profits) and consumers (individual well-being and low prices).

An important potential solution for externalities is to increase education and awareness of the problem (one of the goals of this book!). Companies could give up some of their profits, and consumers could cut back on some of the products they had been purchasing, in order to protect the climate for future generations. Indeed, some of the most profound changes to our society (in terms of the environment, but also much more broadly) have been led by exactly this sort of movement. How should we think about the need for policy, and about what type of policy is best? I would argue that the role for policy is twofold: (1) to create more, or faster, environmental change than is happening through current actions and (2) to accomplish the change in a way that minimizes cost to all parts of society. Achieving cost-effectiveness in an equitable way across society, and especially protecting the most vulnerable subgroups, requires careful consideration of policy design and the distribution of any revenues.

Cost-effectiveness

The key to understanding cost-effectiveness begins with a thought experiment. Imagine making a list of every opportunity available to reduce greenhouse gas emissions, being very specific. Next to each entry write down how many emissions are saved and what the activity will cost. The cost you enter for each item might not always be in dollars—sometimes it could be measured in terms of lost comfort, time, or convenience, for example. The list should be very specific: my walking to work instead of driving could involve a different cost (based on how far I live from my office, the local weather, how much I enjoy walking, and so on) than someone else’s walking to work. Your list of possible actions to help solve climate change, therefore, should have a different entry for “walking to work” for every person and every day; sometimes it will be expensive or uncomfortable, and sometimes it will be cheap and easy. Similarly, the cost of installing solar panels rather than buying electricity from the grid can differ greatly based on geography and the type and angle of the roof on a house. Therefore, your list needs a different entry for “rooftop solar panels” for every house in the world.

Notice that your list should also contain many different entries for things that companies can do, along with the cost of those actions. Google’s loss in profits (usually a good measure of cost for actions that companies take) from making its data centers carbon-free might be very different from Alcoa’s loss in profits from making its aluminum-smelting plants carbon-free. The carbon savings are probably very different as well.

Next in the thought experiment, sort your entire list based on the lowest cost per ton of greenhouse gas emissions avoided. With a complete, sorted list in hand, achieving cost-effectiveness becomes quite easy: simply start at the top of the list, require each individual or company to complete the listed task, and continue down the list until the climate challenge is solved. This will change the environment for the better, using only the very cheapest items on the list (because you sorted it before deciding which actions to require). That’s the definition of cost-effectiveness. If a government policymaker had access to the complete list and could enforce all the actions on it even when they occur inside people’s homes, then the government could do very well on a cost-effectiveness goal even if using command-based rules (rules that mandate particular technologies or actions). The government would be able to mandate each successive item until the carbon goal was reached.

As you have probably guessed, the problem in real life is that we cannot make, or even come close to approximating, this master list. There are simply too many actions and too many different people and companies involved to figure out something like who should and shouldn’t be walking to work, which houses should have solar and which shouldn’t, which companies need to go carbon-free or not, and so on.

Happily, a market-based policy such as a carbon tax is capable of letting individuals and businesses in the economy reveal their own places on the list. For example, if the government raises the price of emitting carbon dioxide, it will make gasoline more expensive and some people will start walking to work. The people who start walking to work happen to be exactly the same people who would appear near the top of your imaginary list! The people who keep driving, on the other hand, will be the ones farther down on your list, whose actions would be more costly.

In contrast, a command-based policy to require people to walk to work (for example, by taking away parking permits or license plates) could never fully distinguish between people in different places on the list. No matter how much information government tried to get, it would almost certainly still “scramble” the list, taking away parking permits or license plates from some people who find it very hard to walk to work, while accidentally leaving parking permits and license plates in place for other people who would be perfectly happy walking to work if they were asked to.

The fundamental difference between command-based and market-based policies is in how government chooses who has to take which actions, and in the likelihood that that choice matches up with the people and actions at the top of the hypothetical master list. Command-based policy, by its very nature, does the picking and choosing within the law itself—regulators perform often very complicated analyses to decide who should be subject to a rule and who should be exempt and which exact actions should be taken. While such analysis and detailed lawmaking can help get a little closer to matching the true list, there is simply not enough information available to do it very well.

Market-based policy, as championed by most economists, is easier to create, easier to enforce, and better at matching the actions near the top of the cost-effectiveness list. Best of all, it can do this without even knowing which items are cheapest. Furthermore, it also adapts automatically as technology changes. For example, swapping my gasoline car for an electric car might be expensive and difficult for me right now but a much better choice for me in 5 years. A carbon tax would automatically incentivize my purchase of an electric car at the right time for me, and my neighbor’s electric car at the right time for them.

There are several ways to create price signals to discourage greenhouse gas emissions, but the one we will consider in our examples is the simplest, and most economists would say best, market-based policy: a carbon tax. How does a carbon tax work? Most companies are very good at maximizing profits and minimizing taxes and so will be able to figure out which of their possible actions to reduce carbon emissions will be cheaper (and thus result in more profits) than paying the carbon tax. Likewise, individuals make many decisions every day to make their lives better (maximizing “utility,” in the language of economics). A carbon tax creates a price signal that discourages people from buying products that are damaging to the climate and it incentivizes a whole series of small actions on energy conservation that, when taken together, can have a transformative effect on climate.

Individual choices and mistakes

The role of individual choices and actions in responding to a carbon tax raises an important potential problem with the policy: What happens when individuals can’t figure out which actions will save them money? They might see a high price for a carbon-intense product on the shelf (the high price would be caused by the carbon tax) but just keep on buying it anyway because they don’t know about alternatives with lower carbon intensity that are now cheaper than their old choice. Alternatively, someone could be attracted by a small subsidy on a carbon-free product but later find that using it costs them a huge amount in inconvenience and lost time.

Either of these two mistakes in decision-making could be corrected by a command-based policy that forces people to do items near the top of the cost-effectiveness list and prevents them from doing items that are too far down on the list (and so are too expensive to be worthwhile). Such policy, of course, would be very difficult to write, since the correct decision could be different for different individuals. An impossibly large amount of data would be needed for the government to figure out the correct mandate for everyone. Finally, enforcement could be a problem because it is often impossible to observe everyone’s actions carefully enough to ensure compliance.

An increasing amount of work is being done in economics to better understand when consumers make good decisions and when they might need intervention that helps guide them toward the right choice. For example, suppose a consumer sees two nearly identical twelve-packs of tennis balls next to each other on the shelf. Brand A has a price of $9: it costs the company $5 to make the tennis balls, it has to pay $3 in carbon taxes to the government, and it wants to keep $1 in profit. Brand B has a price of $7: it costs the company $6 to make the tennis balls in its carbon-free factory, and it also wants to keep $1 in profit.*

If the tennis balls are the same quality, we would expect the consumer to choose Brand B in order to save money. But, what if we observe that some (or even most) people are still buying Brand A?

Brand A was cheaper before the carbon tax, so maybe these people are just repeating habits from the past. Some authors have called this kind of mistake an “internality” (that is, losing money or utility because of an internal mistake) or referred to it as an issue of “inattention.” Another reason we might see people staying with Brand A is that they don’t know the two brands are the same quality and don’t want to take a risk.

If the two brands of tennis balls are in fact identical in every way except for their carbon emissions, the government could fix any potential consumer mistakes by writing a command-based regulation to remove Brand A tennis balls from shelves, forcing people to make the correct choice. Under these circumstances, such a command-based rule would be more cost-effective than a carbon tax.

Of course, in the real world, the two brands might not be exactly the same quality. Furthermore, the aspects of quality that differ might matter more to some tennis players than others. If this is the case, then neither the command policy nor the carbon tax could produce exactly the right decisions. Some players should switch to Brand B to save money (and society would benefit because of the carbon reduction), while other players should stick with Brand A (because some aspect of quality is worth more to them than the $2 price difference).

In the application in Section 12.4 In Depth: Incentives in US Automobile Policy, we will consider the choice of which car to buy. This is a much more complex purchase decision than we make for a pack of tennis balls, and it is also much more consequential if a person makes a mistake and ends up regretting the choice.

*Notice that the company’s decision to build a carbon-free factory might have been prompted by the carbon tax. The incentives can operate simultaneously on both the consumer and producer sides.