Tuesday, June 23, 2009

Free giveaway!

After beating the drum against Waxman-Markey's free giveaway of a sizable fraction of its carbon allowances, I think it's time to clarify some economic basics. Most commentators who oppose free allowances assume that lawmakers are acting in bad faith, rewarding influential industries with thinly disguised handouts. No doubt this is an important part of the story. But I also think that many policymakers genuinely don't understand the issue: they really think that "transitional assistance" to firms will protect American jobs and production.

This is, of course, wrong. It's made dangerous, however, by the fact that it seems so plausible. Won't American companies retain more jobs if they aren't burdened by having to pay for permits?

The flaw here is simple. In the sense that's relevant to profit-maximizing companies, everyone pays for emissions permits. Firms that are forced to buy permits at auction or on the open market pay in the obvious, explicit way. But firms that receive free allocations also pay, implicitly. Each permit they use is one that they can't sell, and the marginal cost of carbon emissions remains exactly the same. Whether we auction the permits or hand them out makes no difference: the profit-maximizing course of action will not change, and firms will hire or fire the same number of workers.

Aren't I overstating my case? Not really. Under even the most imaginative scenario, the benefits to actual laborers (rather than shareholders) from this policy are minimal. Perhaps the cozy financial situation of firms that receive free allocations will make it more difficult for them to lay off workers, from a purely public-relations standpoint. But when soft influences like public image conflict with hard profit maximization, this economist's bet is on the latter; and regardless, the vast majority of any job cuts will come through attrition rather than immediate layoffs.

Most of the time, policymaking is hard—there's a legitimate tradeoff at the heart of almost every policy dispute. This is not one of those times. Handing out allowances is a simple giveaway to firms and their shareholders, and it needlessly makes Waxman-Markey less progressive.

(You can find a extensive post on the topic here.)

7 comments:

Gary said...

"...the profit-maximizing course of action will not change, and firms will hire or fire the same number of workers."

Decision to use or sell the permits won't change, but that doesn't mean decisions to hire or fire workers will stay the same. If you doubt this, just ask yourself what would happen if a permit for 1 ton of pollution cost $1 trillion.

Anonymous said...

Gary,

I'm not sure I agree with your assertion that charging $1 trillion for a permit is a counterexample to Matt's argument. First, the only way a permit "costs" $1 trillion is if a different entity is willing to pay $1 trillion for it. Let's suppose the government decides to charge $1 trillion per permit. Clearly, no one will buy a permit, and all businesses will go out of business. The beauty of this system is that this outcome is in fact efficient! Society (or at least the government) values the services of the industries less than it values clean air, so it's better for the industries to go out of business than for them to keep functioning and still pollute.

Now, suppose the government decides to give away these $1 trillion-dollar permits for free. So, a few businesses get them and a few don't. Now, the ones who do get them have the opportunity to sell them to the ones that don't. But, common sense tells us once again that businesses are still not willing to pay $1 trillion for these permits. So, if anyone does decide to sell, it'll be at a much lower price -- say $1000. What this means is that the government hasn't given away trillion-dollar permits: they've given away thousand-dollar permits.

That the cost of holding a permit is what a company could get by selling it is a very fundamental idea is economics (opportunity cost) that is often misunderstood and frequently overlooked, usually because it's counterintuitive sometimes. I'm not familiar with the auction system the government is proposing, but any system that allows companies to bid on the prices of permits will aid efficiency.

Gary said...

Anonymous,

You've agreed that all workers will be fired if the government sells at $1 trillion, and that some amount other than "all" will be fired if government gives permits away (because the trading value will be substantially less than $1 trillion). As long as those two things are true, Matt's claim that firms will hire/fire the same number of workers regardless of the initial method of distribution must be incorrect.

Another way to confirm this conclusion is to think about the value of options. The moment permits are distributed, firms that aren't given permits have the option to buy from the government g and buy from other firms f; firms that are given permits have the option to buy from government g, buy from other firms f, and sell to other firms o. Since the value of an option cannot be negative, f+g<f+g+o always. Thus, firms that are given permits are richer than those that aren't. If you suppose that firm profits have some effect on hiring and firing decisions, then we come to the same conclusion as before.

Gary said...

My mistake: Matt didn't claim firm hiring/firing decisions would be the same regardless of the method of distribution. He said they would be the same whether the government auctions permits or gives them away.

The claim remains incorrect, but half of my argument was irrelevant. The options argument has to hold all the weight.

Matt, what do you think?

Matt Rognlie said...

Anonymous:

Thanks -- I think you explained my argument better than I did! :)

Gary,

You write:

"You've agreed that all workers will be fired if the government sells at $1 trillion, and that some amount other than "all" will be fired if government gives permits away (because the trading value will be substantially less than $1 trillion)."

I think the core of my argument is that the price will be the same no matter how the government initially allocates the permits, as long as it's providing a fixed number of permits. You can think of it in supply and demand terms: if the government is supplying X permits, then there is some price $Y at which the quantity demanded by the market will be X. It doesn't matter how the government gives them out. And since the price of permits determines the profitability of polluting activities, the initial method of allocation won't affect long term decisions to hire and fire workers.

You're right, of course, that companies receiving free permits will have higher profits. But these profits are not conditional on anything they do, and thus they don't have any impact on their economic incentives to hire and fire workers. They might have a slight impact, as I mention, for non-economic reasons -- it'll be difficult for them to explain the need to lay off workers when they're raking in cash from free permits. Free cash also provides cheap financing. But neither of these has much bearing on the marginal cost of production, or the marginal revenue per worker hour, and as a result I think there's very little employment difference made by the government's decision to hand out permits rather than auction them.

Gary said...

Matt,

First, thanks for the stimulating posts and fun discussion!

You said, "I think the core of my argument is that the price will be the same no matter how the government initially allocates the permits, as long as it's providing a fixed number of permits."

If the only allocation methods we consider are auction and giveaway, I agree! However, if you really stick by the any method of allocation statement, and we consider the possibility that the government sells them at some fixed price, your position is untenable.

Thanks for touching on the issue of financing. To the extent that capital constraints affect investment and expansion decisions for firms, windfall profits absolutely affect the number of workers hired/fired. This is indeed an economic effect that can be analyzed at the margin. We can debate the magnitude of the effect (I doubt we would disagree much), but I don't believe we can debate the principle.

Matt Rognlie said...

"If the only allocation methods we consider are auction and giveaway, I agree! However, if you really stick by the any method of allocation statement, and we consider the possibility that the government sells them at some fixed price, your position is untenable."

Ah, I see. I never meant for "any method of allocation" to include the possibility of selling permits at a fixed price (I was thinking in the frame of cap-and-trade where there's only a fixed supply of permits), but I understand that my wording here wasn't very clear on this point, and it's a good idea for me to be more explicit about this in the future.