The petrol price is about to get pricier

As I noted in this post earlier in the week, my ECONS101 class has just covered the supply and demand model. Once you've seen it and you know how to apply it, it's hard not to see supply and demand everywhere. Take this article from the New Zealand Herald last Monday:

Petrol prices in New Zealand are the highest in nearly six months and commentators in other countries are warning there could be more pain to come at the petrol pump...

The Daily Telegraph reports Libyan National Army leader Khalifa Haftar has global oil markets in the palm of his hand and the international community is powerless to stop him.

His lightning-strike campaign across the North African coastal plain is another reminder of how vulnerable the world's most important commodity is to political turmoil...

There are lots of points in the article that explain why oil prices (and along with them, petrol prices) are likely to rise in the future. As an illustration though, let's just focus on the effect of a disruption in the supply of oil from Libya. The impact on the market for oil is shown in the diagram below. The market is initially in equilibrium, with a price of P0, and Q0 oil is traded. The events in Libya reduce the supply of oil (from S0 to S1), because at each and every price there would be less oil available. The price of oil increases (from P0 to P1), and the quantity of oil that is traded (and consumed) falls from Q0 to Q1 (but note that the decrease in quantity is only small, because the demand for oil is very inelastic - the demand curve is very steep).

The higher price of oil flows through to petrol prices, because oil is the key input into the production of petrol. Higher oil prices means that the costs of petrol production increase, which reduces the supply of petrol (or shifts the supply curve for petrol upwards). So, the impact on the market for petrol is also shown in the diagram above - a higher price at the pump.

Stocks vs. flows... Tech firms vs. Ireland edition

The market capitalisation of a major tech firms is a big number. The Gross Domestic Product (GDP) of a country is also a large number. However, it doesn't mean that these two large numbers are comparable, because they're measuring different things. This week's example of journalists getting this horribly wrong is from Politico, in the context of Ireland's reluctance to get on the wrong side of the large tech firms by regulating them:

It’s a reasonable fear in a place where the tech companies’ resources far outstrip the government’s. Google’s market capitalization, by itself, is twice the size of Ireland’s gross domestic product. Facebook’s is larger by about a third.

“Regulation is a particularly fraught area for a country like Ireland because they have less leverage [over companies] than a bigger country,” said Josephine Wolff, a professor of public policy at the Rochester Institute of Technology. “If Facebook announced tomorrow, ‘We’ve had it with Ireland, we are closing down our office,’ that would be a huge deal with political and economic consequences for the whole country.”

The point made in the second paragraph is quite reasonable. However, the illustration in the first paragraph is not. The problem (as I've mentioned many times before, such as here and here and here and here) is comparing stocks with flows. The size of an economy (as measured by GDP) is a flow of resources for a single year. Google's market capitalisation is a stock (a measure of its total value), not a flow for a single year.

An appropriate national comparator to a firm's market capitalisation is the discounted value of all future GDP, not one year's worth of GDP. However, if you want to compare the resources available for a legal battle, then market capitalisation is not appropriate, because that doesn't tell you how much resources Google has available. And neither does GDP tell you how much resources the government of the Republic of Ireland has. A comparison of liquid assets (e.g. cash) might make more sense. It probably still comes out in favour of Google over Ireland, but at least then the comparison would be reasonable.

Environmental activists should buy coal!

My ECONS101 class is on a teaching recess at the moment. Just before the recess though, we covered supply and demand. So, it's timely for me to consider a little bit of supply and demand here. I really liked this recent Marginal Revolution post by Alex Tabarrok:

Since climate change and what to do about it are in the news it’s time to re-up an underrated idea, buy coal! Carbon taxes increase the price of carbon and induce economic and technological substitution towards lower-carbon sources of fuel in the countries that adopt them. As carbon-tax countries reduce fuel use, however, non carbon-tax countries see the price of their fuel decline. Thus, unless all countries join the tax-coalition, there is leakage. Supply-side policies are an alternative to demand supply policies. The United States, for example, could buy out and close coal mines, including giving the workers substantial retirement/reallocation bonuses, thus reducing the world supply of coal which is still the largest source of C02 emissions.

I'm going to take things in a slightly different direction though. Let's consider the actions of environmental activist groups (or activist governments, if you like), and how they impact the market for coal. [*] The standard approach has been to try to convince consumers (or shame them) to reduce their use of coal. To the extent that the approach is effective, it reduces the demand for coal. In the diagram below, the coal market is initially in equilibrium, with a price of P0, and Q0 coal is traded. When demand decreases (from D0 to D1), the price of coal falls (from P0 to P1), and the quantity of coal that is traded (and consumed) falls from Q0 to Q1. Less coal is consumed. Job done! The environmental activists can pack up and go home for a well-earned kombucha.

Not so fast. As Tabarrok notes, the lower price of coal may encourage other countries to use more coal. Perhaps they build more coal-fired power plants to take advantage of the lower-price energy. Demand for coal increases, and we end up back where we started.

An alternative, strange as it may seem, may be for the activist groups to use their funds to buy coal mines, and shut them down. Provided the groups' property rights over the mines are secure, they can be sure production will not start up again. That has the effect of decreasing supply, as shown in the diagram below. Supply decreases (from S0 to S2), which pushes the price of coal up (from P0 to P2), and decreases the quantity of coal that is traded (and consumed) from Q0 to Q2. This approach has the added benefit that it reduces the incentives for other countries to turn around and consume more coal, because coal is now more expensive than before. Of course, this approach may be more expensive than simply trying to convince consumers to consume less, but if it is more effective in the long run, then why not try it? [**]

For completeness though, what if the environmental activists did both (convincing consumers to consume less, while simultaneously buying up and closing down coal mines). Then we have the situation below, where demand has decreased (from D0 to D1) and supply has decreased (from S0 to S2). The quantity of coal traded (and consumed) falls much further (from Q0 to Q3), but the effect on price is not easy to determine. In the diagram below, the price falls (from P0 to P3). However, that is only because the decrease in demand is drawn as being larger than the decrease in supply. If the decrease in supply were larger, the price of coal would have increased. There is also an unlikely possibility that the two changes exactly offset and the price of coal stays the same. So, in this situation we can say for sure that the quantity of coal will decrease, but the change in the price of coal is ambiguous (and so is the change in incentives for other countries to use coal).

Overall though, at the least I think there is a case for activist groups to explore this possibility. As Tabarrok concludes:

A program to leave coal in the ground could easily pay for itself in lives saved and climate stabilized.

*****

[*] For simplicity, the market diagrams I've drawn in this post ignore the fact that coal generates an externality (an uncompensated impact on those who are neither the supplier nor consumer of coal). However, drawing them with the externalities would make no difference to the underlying story in terms of the change in prices or quantities, and would simply make the diagrams more complicated. Let's keep things simple!

[**] Of course, an economist would point out that the reason 'why not' could be that the added costs of this higher-cost approach outweigh the benefits. But that requires more analysis than we have space to do here, and is a job for the environmental groups (or their pet economists).

Book review: Pricing Lives

The value of a statistical life (VSL) is a fairly difficult concept for a non-economist to get their head around. The fact that economists or policy makers might want to place a value on human lives seems like an affront to many people. However, the VSL is an important component of cost-benefit analysis. Consider the decision about which stretches of road safety improvements should be added to first. You'd probably want to spend your resources on road improvements wisely, targeting them at the stretches where the benefits outweighed the costs by the greatest amount. That calculation requires an assessment of the value of the benefits, which include the resulting number of lives saved.

The VSL is important for policy, which is why I devote a serious amount of time to it in my ECONS102 class. However, it's not the sort of concept where I would have expected to see a book targeted at general readers. So, Kip Viscusi's Pricing Lives was an interesting surprise to me. However, if anyone were going to tackle the challenge of writing a book on VSL for a general readership, it would have been Viscusi. He didn't invent the VSL (that honour goes to Nobel Prize winner Thomas Schelling), but has arguably had the greatest influence on its use and development, and has made countless research contributions in this area.

The book is relatively easy to read, and especially so for someone with a basic grounding in economics. However, I found it somewhat repetitive (even to the extent where some of the endnotes also appeared in the text), and it could easily have been shortened substantially without any loss to the narrative. Viscusi starts by defending the concept of monetising the VSL, rather than leaving lives saved as some un-measured benefit of policy:

In an earlier study of the use of benefit-cost analysis to value water-resource projects, I found that government agencies placed almost exclusive emphasis on the monetized effects... In that era, environmental consequences received qualitative discussion but were largely set aside in favor of emphasis on the series of tangible economic benefits that were monetized.

In other words, the only things that count in decision-making, are unfortunately only those things that can be counted (and measured). Which is why the VSL has been such an important policy tool. However, Viscusi sees the VSL as being underutilised, and the main aim of the book is to open the readers' eyes to the potential:

...to greatly broaden the menu of uses of the VSL, which to date has largely been confined to benefit assessments in the analysis of proposed major regulations.

Specifically, Viscusi presents three main opportunities for the VSL: (1) in the realm of business decision-making, such as in deciding which product safety improvements are worthwhile (and which are too costly to implement); (2) in the courts, such as in deciding on appropriate damages awards that would adequately incentivise safety improvements; and (3) a broader use in government agencies, such as in the size of regulatory sanctions.

I found the discussion of product safety to be especially good, especially the unexpected incentive effects caused by initial corporate use of benefit-cost analysis:

In the 1970s, 1980s, and 1990s... all the major US automobile companies undertook detailed economic analyses of the cost and risk implications of safety-related product characteristics. However, frank assessments of the risks and costs of different design possibilities led these companies to be vilified in the press and penalized by juries for undertaking such safety studies, not simply for specific alleged deficiencies in the analyses... These adverse experiences no doubt have contributed to the corporate abandonment of systematic assessments of safety decisions.

The courts used previous safety assessments against the companies, so the companies responded by ceasing to conduct rigorous safety assessments. Viscusi presents an (obvious) solution to this dilemma, which is to make the assessments inadmissible in court, provided the company used an appropriate measure of the VSL in assessing the benefits of the safety-related product characteristics.

The book does a great job of outlining some of the other controversies related to the VSL, such as whether the VSL should vary by age (should lives saved of younger people be worth more than lives saved of older people) or income (should lives saved of wealthier people be worth more than lives saved of less wealthy people). While acknowledging that context matters, Viscusi appears to lean towards 'no' in terms of age, and 'maybe yes' in terms of income (but only when the associated policy costs would not spill over onto other groups). The book also tackles the difference between statistical lives and identified lives, which is particularly challenging (and not easy to explain, so I will refrain from doing so here).

Overall, this is a broad book on a seemingly narrow topic. Definitely, this is recommended reading for those with an interest in the subject of policy analysis, or law and economics, and especially for those wanting to understand the VSL better. This is an important policy concept, and destined to remain so.