Incentives to reduce pollution

The UK is considering a scheme to help remove diesel cars from the roads. This is after years of encouraging diesel fuelled cars by taxing it more favourably than petrol.

The reason for this scheme is that it is now considered that diesel fuel is more polluting than petrol. This is especially true of older diesel engines (mainly an ageing thing I think). The negative externalities of consumption associated with diesel are now thought to be more severe than previously thought (indeed it was thought diesel was better than petrol for the environment because less was needed to travel the same distance).

The proposal might be called a 'nudge' by behavioural economists, because they don't really understand subsidies! This scheme proposes to give a minimum payment, in excess of the market value of old diesel vehicles, to incentivise people to trade in their old vehicle for a brand new one. The new vehicles will emit less pollution and there is therefore a win for the environment as the market moves closer to allocative efficiency.

The scheme will effectively shift the demand curve for new vehicles to the right with the price difference between what the consumer is prepared to pay and the price they must pay covered by the government. Not everyone will trade in their diesel cars and vans, but some will and this will help efforts to reduce harmful pollution.

There is an interesting benefit for car and van manufacturers of course, they sell more new vehicles and so there will be a boost to Aggregate Demand and employment. The benefits will go to all manufacturers, not just those in the UK and so a Europe wide scheme would make the most sense.

The Daily Express covers the story here

This article has most relevance to IB who look at market failure in more detail than VCE. It is, however, a useful example of how governments can intervene in markets to improve resource allocation for everyone. Please note the Daily Express is not the only paper to cover this and I'd never recommend it as a serious newspaper generally, but I thought the Guardian and BBC deserved a rest.

Justifying protection in the book market

Books in Australia are expensive. Really expensive. It has been well known that buying books from Amazon or 'The Book Depository' and having it shipped from the UK or USA has been cheaper than walking down to Dymocks. The reason is protectionist measures imposed by the government.

It is illegal to import for resale any book that an Australian publisher has the rights to. Therefore if an Australian publisher sells a book at $50 and a UK or US publisher sells the book for $15 then buying it in Australia leaves the consumer $35 worse off and until the internet there was nothing you could do about it.

The rules that cause this are called the 'parallel import rules' and have applied in several sectors. Recently the government accepted the recommendations of a report that all such rules should be abolished.

The argument for the rules on books has been that it protects Australian authors. By protecting Australian publishers from competition this raises all book prices.  Therefore the Australian authors can be published because the returns from Australian publishing are high enough to justify the investment.

Of course the big loser is the Australian book buyer. They pay more for all books, regardless of who wrote them. The big gainers are Australian publishers who can charge more because they are protected from competition from international publishers. For example a Harry Potter novel could be published overseas and in Australia but the overseas copy cannot be sold in Australian bookshops despite being a third of the price.

Would fewer Australian authors be published if the rules were dropped? Probably, but only because their product was uncompetitive - that is consumers preferred overseas alternatives. That is improving allocative efficiency.

Would fewer people be employed in the publishing industry if the rules were dropped? Certainly, because printing overseas is very much cheaper than printing in Australia. This means improved productive efficiency. (Many point out that overseas printing is also of much higher quality as their equipment and technology is superior. Improved allocative efficiency too.)

Would fewer people be employed in book selling in Australia? Probably not. Lower prices will increase book sales if the law of demand is right. Of course they may be employed differently to at present, but there is no reason why bookselling should see less activity at all.

Therefore the parallel import rules are an example of old fashioned protectionism with little to recommend it. The losers are the Australian public who will see their consumer surplus transferred to publishers or lost completely.

The Guardian covers the story here

This story is relevant to both IB and VCE students. IB students will study protectionism in international economics and VCE students will also look at the goal of external stability and policies to achieve it.

Increasing industry concentration a concern

Economists have long understood that competition between firms brings the advantages of lower prices, improved quality and greater consumer choice. This is because firms deliver on these or they will be competed out of the market. 

The Australian Competition and Consumer Commission (ACCC) chairman has warned that market concentration (the percentage of market share held by the biggest firms) has risen to a level where consumers are possibly going to be worse off.

If a firm has monopoly power then they typically charge more and sell less, but earn higher profits. Over the last few decades mergers and takeovers have led to a very high proportion of Australian output being concentrated in the top 100 firms.

This provides a problem for the ACCC who regulate competition. The article below suggests that a change of rules whereby the firms that merge or want to takeover another have to prove the result will not harm competition. At present the ACCC have to prove it would harm competition.

An interesting point made by the ACCC is that if we want the benefits of economies of scale to work through to lower prices then we have to maintain a competitive environment. In other words a merger/takeover may improve productive efficiency but harm allocative efficiency.

The ABC cover the story here

This article deals directly with competition policy in Australia so is directly relevant to VCE economics. This is a part of IB economics also, and the harm that monopolies do to efficiency is often visited on Paper 1 of Higher Level in questions on the theory of the firm.

What is the best way to achieve equity?

Equity is a measure of fairness, and therefore a matter of opinion. The difference of opinion extends beyond what the best distribution of income is to how we should achieve it.

Some people believe that the way to achieve equity is through evening up in-work income. That can be done by raising minimum wages and taxing incomes progressively. Others believe that the best path is to pay benefits to those who require additional income. Both approaches will help reduce income inequality.

In Australia there is presently a debate between government and Trade Unions on the setting of the minimum wage. Australia has for many years had a very high minimum wage, but it has been falling in terms of the proportion of average wages this represents.

The Trade Unions want the minimum wage raised so that it is maintained at 60% of average incomes. The government does not want to commit to that because it fears that this may raise unemployment. (That would be cause real wage unemployment where the minimum wage in some industries is set above the market equilibrium.)

This is actually an argument of equity vs efficiency. There is no doubt that a high minimum wage promotes equity, the difference in take home pay will be made smaller. However it may harm efficiency.

Markets work through incentives. Earning  higher profit incentivises  firms to lower costs and improve quality in order to sell more products. It is a similar issue with workers, they are incentivised to work through wages. Higher wage rates attract more hours of work from workers.

If the minimum wage is too high there are two possible detrimental effects.
1. Firms cannot pay different rates of pay to different workers below the minimum wage
 A worker who is more productive should earn more than one who is less productive. However if both workers value to the firm is less than the minimum wage then both receive the same wage or, possibly, neither is employed.

2. The incentive to work harder and achieve improved skills and position is removed when there is equality in payment. The rational choice is to do the easier job yet get paid the same. Any move towards greater equity in income risks enhancing this effect and the economy suffers.

Overall this means that the economy is denied the competition it needs to achieve productive and allocative efficiency and as a result resources are misallocated.

There is no right answer to the question of the 'best' distribution of income. The trade-off between equity and equality is a real one though and must be considered in any policy proposal.

The Guardian covers the story here

This matter is of value to VCE students as the minimum wage is a key part of policy for the goal of equity. For IB students this has wider implications including the causes of unemployment and supply side policy.

Is Australian privatisation making the economy less efficient?

Australian Competition and Consumer Commission chairman Rod Sims has stated that in his view many Australian privtisations have made the economy less efficient and led to prices in those markets being higher, not lower.

Privatisation is a supply-side policy and takes two broad forms, one is removing rules from a market (called deregulation) and the other is where government owned corporations are moved to private ownership (denationalisation). Denationalisation is usually accompanied by the breaking up of the monopoly power of the organisation concerned by allowing new firms in to compete with it. A classic case is in telecommunications where Telstra in Australia and BT in the UK had monopolies on providing phone services before privatisation.

The aim of privatisation from an economists perspective is to move the market back to one where increased competition drives down costs and so increases allocative and productive efficiency. Allocative efficiency is provided by firms trying to better meet the wants of consumers. 

Successful privatisations lower the barriers to entry (often through deregulation and denationalisation together). In addition to the efficiency gains there are also improvements in productive capacity, increasing the level of Aggregate Supply. 

Governments have another motive in privatisations. They want to raise money. They can use the money to cut taxes (popular) or reduce government deficits or debt. Rod Sims is accusing the government of putting this motive in front of the others and as a result harming the interests of consumers.

A classic case is the sale of Medibank health insurance. The Abbott government shamelessly allowed premiums charged by health insurance companies to rise quickly prior to privatisation to make the potential profits look more attractive and drive up the share price.

The Sydney Morning Herald covers the story here

This article has interest to both IB and VCE students. IB students will recognise it as an example of how poorly planned privatisations can create private monopolies and work against consumer interests and failing to deliver the hoped for gains. VCE students can use it as an example of supply-side policy and a legitimate criticism of such policies in Australia.

Regulating monopoly power - a good idea?

The European Commission has jut rules that there cannot be a merger of two of the four mobile phone network operators in the UK. They have done this because they say the reduction in competition this would involve could harm the interests of consumers.

There was a proposed takeover by the '3' network of the O2 network. The cost of the deal at nearly 13 billion Euros was enough to attract the attention of the EU Competition Commissioner.

The merger was banned because the EU feared that the result of having just three providers in the market would confer too much monopoly power on the remaining firms. They argue that prices would rise and the service quality fall as a result.

The reason that a high concentration ratio can be bad for consumers is the loss of efficiency that can result:

Productive efficiency falls because there is less competition and no need to keep costs low. There is also less incentive to invest in the service to improve because the chances of loosing market share is minimal.

Allocative efficiency is reduced as there is less need to provide consumers with an innovative new service and high quality as the alternative services are diminished.

Dynamic efficiency is reduced because there is less need to invest. An important point here is that the three remaining firms are more likely to act in their mutual interest and not compete strongly. It is not collusion, that is illegal, but a 'Nash equilibrium' becomes more likely. Each firm realising that strong competition is effectively cut throat they act in a way that maximizes mutual profit.

This is an excellent example of competition policy in action. Some will argue that banning the merger it is a bad move in the long-run as mobile networks need to become international, not national. That's a trade-off of long-run efficiency gains for short-run losses the EU is unwilling to make.

The BBC covers the story here

The detail of this story is of most interest to IB students studying market structures and government intervention. However VCE students should see parallels to the operation of the ACCC and the costs of monopoly power.

Should there be a 'sugar tax'?

There is discussion around the world about putting a tax on sugar. In particular the sugar in fizzy drinks is causing concern with young people consuming so much sugar that it is leading to an obesity problem.

When people become overweight they are more susceptible to illness, such as heart disease. This leads to higher medical costs which are, in most countries, placed on governments and also leads to lower productivity. The economic problem is one of negative externalities in consumption.

The diagram below shows how negative externalities lead to a market failure in the consumption of sugar.

The demand curve (D) is also the Marginal Private Benefit Curve (MPB). The market equates supply and demand at P1, Q1. The problem is that households do not consider all of the costs of consuming all that sugar in the fizzy drinks. The Marginal Social Benefit of consuming sugar is less than the perceived private benefits.

This makes sugar a 'lack of information good' and the market oversupplies the good above the optimum amount (where MSC = MSB which defines allocative efficiency) by the amount Q1 - Q*.

So will the proposal to impose a tax on sugar work? The answer is that if the tax is of the right amount it will. In the diagram a tax of P* - P2 is imposed and the equilibrium quantity falls to the social optimum 0Q*.

There are difficulties. The BBC article suggests that is there is a 20% tax on fizzy drinks will reduce sugar consumption by 16%. That suggests demand is really quite inelastic. If the tax was on all sugar then it would be more effective. Another difficulty is that we actually don't know what the optimal consumption of sugar is, or the elasticity of demand, so the 'right' tax level is guess work.

A tax on sugar will reduce consumption, it will internalize the externality due to the information failure and provide revenue to help fund health services for those who need them. For economists it's a good solution.

The Age has an article here

The BBC have a story on  a UK proposal here

This article is aimed at a level of difficulty that is most suited to IB Economics (and A level). However VCE students need not worry about the labels MPB and MSC,  simply that the demand curve does not include the true benefits of consuming the good.

Anti-dumping measures, another crude attempt to resist efficiency?

Australia has decided to put an import tax (a tariff) on Italian canned tomatoes. Their argument that the Italians are pricing their product unfairly.

The one producer of canned tomatoes in Australia, SPC Ardmona, owned by Coca-cola Amatil, claim the Italian tomatoes are being 'dumped' on the Australian market.

The test Australia has applied is that Italian producers sell their product for less in Australia than they do at home. While this definition is seen a lot dumping is actually selling a good at less than the cost of production. Dumping is legal under World Trade Organization rules unless the foreign country can reliably show the negative effects of the exporting firm on the domestic producers.

It seems very unlikely that the Italians are making a loss. Italy's economy is in a perilous state and taking a long term loss just isn't an option.

So what might be the motive? A clue might come from one of the supporters of the move, 'The Australian Campaign'. This group argue that we should all buy Australian products in order to keep jobs in Australia. Never mind the quality or price.

In the short term such a strategy may work. However in the long run this policy would allow inefficient and uncompetitive firms to survive. Consumers will be much worse off as they pay higher prices and exports would dwindle as firms, protected from competition, could lose world market share. 

It is much better for jobs and prosperity to buy the most competitive goods, force domestic firms to compete or die and so allocate resources efficiently. It is very sad that protectionism continues to be given any credibility by such 'anti-dumping' actions,

In fact most anti-dumping tariffs last less than two years. They are withdrawn before the WTO can rule them as bogus.

The effect of the measure will raise profits and sales at SPC. The diagram shows this.

At present tomatoes sell for 60c a can. Total sales are 0Q2 with Q2 - Q1 being imported. Australian firms only produce 0Q1.

After the tariff the price rises to $1.40 a can and sales fall to 0Q4. Imports fall and domestic output rises to 0Q3. 

The problem is that the consumers lose out.The whole coloured area is lost consumer surplus. The green area represents inefficient production costs and the red area consumer surplus transferred to domestic producers (SPC).

The Sydney Morning Herald covers the story here

This article is directly relevant to VCE Unit 4 on policy goals and example of trade policy. IB students will study this is Unit 3 on international trade. The diagram shows how to apply theory to a real life example.

Update: Rather good article here,published on 16th Feb.
The Drum article is here

When is free trade not free trade?

Australia has 'concluded a free trade deal with Japan' and will sign another one with South Korea in the next two days. This is an important step forward, but isn't properly free trade.

In the eighteenth century Adam Smith, and in the nineteenth David Ricardo, showed that everybody gains from free trade. Economists have accepted this ever since. It is therefore astounding that any country retains barriers to trade in the twentyfirst century. However some do and so do Australia and Japan after this deal.

There is abolition of tariffs on some goods. Cars from Japan to Australia, for example, will fall from a 5% tariff to zero. But not necessarily all at once. Other tariffs are merely reduced, such as the tariff on beef from Australia to Japan, which was an eyewateringly high 38.5%  will be halved. A 19.5% tax is still huge as a barrier to trade.

Tariffs are not the only barrier to trade. Quota's used to be a popular way to reduce trade and the new deal allows an additional 20,000 tonnes of Australian cheese to be exported to Japan. Another popular barrier to trade is to extol the benefits of local products. Australia is a master of this is their 'Australian owned' or 'Australian made' propaganda.

The simple fact of the matter is that all trade barriers harm the standard of living of countries. What protection (or economic nationalism as it is often called today) does is raise the prices paid by consumers and protects inefficient domestic producers from competition. Competition forces down costs and promotes allocative and technical (productive) efficiency.

Australia suffers more than most developed countries from the protectionist fallacy. People buy into the idea that local jobs are 'saved' by it. All protection can do is delay the inevitable and, usually, when the trade barriers are removed the domestic industry is so hopelessly inefficient it closes. Ask Ford, Holden and Toyota if you need proof of this.

The ABC covers the trade deal here

Dealing with negative externalities

Congestion is an excellent example of an externality. 

By driving along a road you actually hold up other road users. You consider only the benefits of making the journey to yourself and the cost of the journey to you*. However you impose on other road users the cost of a longer journey for them and impose on the world at large the costs of noise and pollution from your car.

The market will allow far too many cars to use a road. You only need to look at the queues of traffic heading into the City in the morning, or out again in the evening.

The reason why there are too many cars on the road is the failure of drivers to consider the full social cost of their journey. The way to correct this market failure is to 'internalise the externality' by imposing a charge on the drivers. This will raise the cost of the journey to them and fewer will want to use the road (simply the 'Law of Demand').

Economists have long recommended 'road pricing' as a solution to the problem of congestion. It meets with a lot of opposition and was recently rejected by the Abbot government when recommended by the Productivity Commission. 

Road pricing means charging road users according to the time of day and level of congestion. It is a variable charge that tries to smooth out the 'peaked demand' of rush hours. By using such a system the market is moved closer to allocative efficiency, the journey times of those prepared to pay is reduced, pollution is lower as less fuel is used and money is raised to subsidise public transport.

Despite the economic sense of road pricing it is unlikely to be introduced anytime soon. There might be a London style congestion charge or a small charge per kilometer on drivers in small areas at peak times. Only Singapore has so far introduced electronic road pricing with variable fees. 

The Telegraph covers proposals for Sydney here

*Actually drivers only tend to consider their fuel costs and not the cost of maintenance, insurance and wear and tear that they have to pay as well. Therefore they underestimate their true costs and drive even more than they would if the full cost of motoring was considered.