Friday, December 30, 2005

The EPA and your wallet

One of the more intriguing results in Thaler’s The Winner’s Curse is the idea that people have an idea of “fair” pricing. The common example is splitting $10 between two participants—Player 1 splits the amount between the two, though both have to agree to the respective amounts in order to actually receive the money. Theory dictates that Player 2 should accept any non-zero amount (as it’s money that they otherwise wouldn’t have)—but in practice, if the amount is viewed as insultingly low (say, $0.05), then Player 2 will reject the bid in Seinfeldian spite and no one gets anything. Evidently, people care not only about their relative values for goods, but about others’ respect of those values.

I can’t help but to think that this is at least partially related as to why people are so upset about paying “too much” for gasoline. People value gasoline at its current price—after all, they are at the pump getting mad—but they remember paying less, and somehow the price increase is insulting. It’s popular to point the finger at oil companies (after all, they have big ships that hurt baby seals), OPEC and natural disasters, but this points to another explanation. As the EPA continues to levy regulation upon regulation, prices continue to rise—and the government is obviously not going to blame itself for the discontent of millions.

It raises an interesting question—who is doing a better job of keeping gas prices high: OPEC, or the EPA? I don’t think either of these are the primary reason as to why gas prices have climbed to their current level—nonetheless, I’d love to see a paper on that topic. OPEC’s effect, I’d imagine, has probably been subject to a Harberger-related estimation. The EPA causes higher prices directly via quality controls, but also introduces a whole host of public choice-related inefficiencies. I’d suspect that the EPA has a rather sizable effect on gas prices. Extend it from the EPA to the entire government and gas taxes could be added in as well.

Higher demand causes higher prices—but so does regulation. The finger should point in that direction too.


Anonymous said...

Do you ever stop to think that maybe the oil companies are exploiting people? It's a matter of fact that the OPEC monopoly allows them to do this. And the EPA plays an important role in protecting resources that are often infringed upon due to negative externalities. Sheesh. You free-market types need to leave the church of milton friedman for once and have a glipse at the real world.


Anonymous said...

It's as if Donald (posting anonymously of course) didn't read a thing. Good post Matt.


pinetorum said...

This is an interesting post, but I would have liked to see you take it one step further and recommend an alternative course of action for the EPA. As a regulatory agency, the EPA indirectly (not directly) causes the price inflation of numerous commodities, including gasoline. By saying the "finger should point" at the regulators, you're implying that they are in the wrong. I disagree. Allowing cheaper, and environmentally "dirtier" gas would lower prices but eventually place a different economic burden on the economy by increasing health and ecosystem problems. I don't know which option would end up costing more, but the situation is not as clear-cut as you make it out. So I'll end by asking again, what role would you prefer the EPA to take in situations like this?

And just for full disclosure, I am a research biologist. So my views are obviously slanted. I am not employed by the EPA, but do conduct research in an EPA lab. And I'm Matt's brother. I'm not an economist, so feel free to slam me and my naive ideas. I won't get angry and start posting anonymously.

And just as an aside, in "The Winner's Curse," what dose theory dictate that Player 1 should offer? That's seems a much more interesting question than what Player 2 should do...

Matt E. Ryan said...

Dirtier environments are almost certainly something that people, ceteris paribus, would prefer less of. The mistake that the EPA makes is that it assumes that all people value a clean environment to the same degree, and "charges" everyone the same amount by imposing regulation and uniformly raising the cost for everyone by the same amount.

The better solution is to internalize the externality and allow for tradable pollution rights. Those that desire to pollute more must acquire the rights to do so. It's similar to desiring more property-- rights must be acquired to achieve that goal as well.

With regards to directly versus indirectly causing the price level to raise, I think it's a matter of how far down the chain of events we can attribute to "directly." The EPA doesn't raise prices, that's true-- but they do impose regulation, and regulation raises prices. In the same light, Exxon Valdez didn't "directly" kill any wildlife-- it just spilled oil.

As to what Player 1 should offer, it depends on a number of things-- communication between the players, whether it's a multi-stage game, whether the game is played more than once, etc. In the simplest one-stage games, mean offers were usually never below 30% range-- well above the theoretical anything-greater-than-zero level. As to what you should offer? Probably the same answer when you know you're holding the best cards in poker early in the hand-- whatever gets you the most money without the other guy running away.

David said...


I agree with your comments, but I would like to play devil's advocate. You said that "The better solution is to internalize the externality and allow for tradable pollution rights". I agree that an internalization of externalities is the best way to go by far, but what about those externalities that are very difficult to internalize due to transaction costs. The glib example, I suppose, is something that harms the ozone. How can the costs imposed on millions be accurately internalized to the person who caused it considering the practical impossibility of identifying the person and the extent of damage? How would we measure the damage? We can't just take people's word on how much they would pay to not have the damage.

Matt E. Ryan said...


The transaction costs of accurately identifying pollution amounts are certainly something to be dealt with. In the original example of gasoline, though, I'm not sure that there would be any additional transaction cost above what knowledge is already available about automobile emissions today. There still exists a problem of who is to make sure that those remain accurate-- but I would rather have taxpayer money spent towards better defining property rights than making sure gasoline is free of additive X in 2006 and additive Y in 2010.

pinetorum said...

Good points, but you've made some errors, in my opinion.

You say that the EPA makes a mistake by assuming all people value a clean environment to the same degree. The EPA makes no such assumption. If all people did value a clean environment to the same degree, there would be little need for the EPA in the first place.

The EPA assumes that all people deserve a clean environment (to the same degree). Very different. The EPA thinks that it's kind of an unalienable right. So it could be argued that the EPA is justified in charging all equally. But I don't think this occurs.

In this gasoline example, the EPA does not "uniformly rais[e] the cost for everyone" as you state. It only raises the cost for those who use gasoline. Those who use more (and thereby pollute more) pay more taxes. If you disagree with the tax, you don't have to buy gasoline at all and can walk everywhere. Unless you live in North Carolina where there are no sidewalks...

So this is somewhat analogous to tradeable pollution rights. The problem with tradeable pollution rights, and pollution in general, is that it is impossible to internalize, to use an economic term. The Tennessee Valley Authority may place a very low value on the environment and purhcase as many pollution vouchers as possible. Populations in Western North Carolina may place a very high value on the environment and live a very clean life, but end up unhealthy because nearby rivers were overpolluted with PCBs. Pollution cannot be internalized and for this reason it is not appropriate to treat it as a tradeable commodity.

No matter how much I may want to, I cannot purchase the right to drive drunk or murder somebody. Pollution is a similar (though much more mild) example.

Matt E. Ryan said...

The fact that the EPA assumes that everyone deserves a clean environment is still an example of preference smoothing. There could very well be people out there that wouldn't pay one cent more for gasoline for a cleaner environment; there could well be some people that would pay $10 more per gallon. The regulations smooth all of these people into one group. At best, the EPA's regulation hit the mean public preference for a clean environment, in which case preferences are balanced but nearly no one's are matched.

The problem, if we're to get into the gasoline issue, is not the gasoline-- it's the cars that people drive. I could drive a hybrid vehicle and someone else could drive an SUV, but we're both still subject to the same tax rate. That example is a bit extreme; but now consider two engines that get the same mileage per gallon, but emit different amounts of pollution. Taxing gas does not get at this problem. It's similar to taxing every cassette tape sold due to piracy. Not every person will use each tape for piracy-related use to the same extent, yet every buyer has to pay the same tax, and hope that everything shakes out in the end. In the meantime, this distorts the pricing mechanism and imposes, among other problems, a deadweight loss.

I would agree that pollution is impossible to fully internalize. This is no reason to impose blanket regulation; tradeable rights have worked in commons-related problems in the past, most notably (in my mind) in Iceland's fishing industry.

The TVA example highlights something that people tend overlook-- there are not to be an endless supply of tradable pollution vouchers. Without a scarcity of vouchers, there's no effective market for them, nor an effective means of preventing pollution. Various principalities, be it at the state, country or city level can decide the level of pollution they want and move forward. Competition between principalities to attract residents will help increase efficiency. Granted, there are still spillover effects-- but taken to the extreme, the spillover effect of LA's smog is negligible on Fairbanks.

Though the TVA example has a much easier solution-- privatize the river.

And, naturally, you can not purchase the right to violate someone else's property rights, as murder is example 1a of that. Alas, I don't believe there exists a commons problem in murder as there does with pollution. (Drunk driving is a more interesting example, though.)

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Cheap RS Gold said...

So my views are obviously slanted. I am not employed by the EPA, but do conduct research in an EPA lab. And I'm Matt's sibling. I'm not an economist, so you may want to slam me and my naive tips. I won't get mad and start posting anonymously.
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