Friday, August 14, 2009

Why the world needs economists

Joe Romm claims that Cash for Clunkers is a good deal (via Bradford Plumer):
BUT as a stimulus that saves oil while cutting CO2 for free — it has turned out to be a slam dunk, far better than I had expected. Indeed, Borenstein points out that “America will be using nearly 72 million fewer gallons of gasoline a year because of the program.” At $3 a gallon — hardly what the price is likely to average over the next decade — that is $216 million a year in gasoline savings.

So the billion dollar program pays the taxpayers back in oil savings in 5 years. That means the CO2 savings are for free!
This all-too-common argument is enough to give an economist an aneurysm. What Romm misses is that consumers already internalize the savings from spending less on gasoline. Paying them extra to junk their old cars for new, fuel-efficient ones amounts to compensating them twice for improved fuel economy, leading to wasteful exchanges where the benefits hardly justify the costs.

This feels like too easy a target, but since otherwise very smart people like Romm inexplicably make this mistake all the time, I think I should clarify with an example. Say that everyone in America attends Mattland, widely revered as the best amusement park in the world. Since it provides such exquisite entertainment, Mattland charges a reasonable price: either $30 for an all-day pass or $5 per hour. Assume further that while Mattland provides a great time to its visitors, its charms naturally wear thin after a while, and the vast majority of Americans choose to attend Mattland for about 4 hours. As optimizing economic creatures, visitors to Mattland choose to pay $5 per hour for 4 hours ($20) rather than the flat $30 fee.

Now the government comes in with its Amusement Efficiency Package and offers to subsidize all-day passes by $15. Everyone switches to the $30 pass, and advocates breathlessly declare that their efforts have saved the average American $20 in hourly fees. Success!

Of course, here it's obvious that there was no actual gain. Prodded by the subsidy, visitors needlessly bought the $30 pass when they would have been just as happy spending $20, and the net combined loss to consumers and the government was $10. Yet this is precisely the argument that Romm is making (and Plumer seems to find convincing)! Perhaps you feel that this is a silly example, ill-suited for a serious topic like energy policy. But as Paul Krugman memorably argued—and I think this case confirms—we need silly, playful examples to understand the essence of our arguments. Somehow the logic is much clearer when we're discussing amusement parks rather than fuel economy.

I don't claim to make any all-encompassing argument against cash-for-clunkers here. Its possible effect as a stimulus is far too complicated to examine in such a small space. Still, as Romm admits and an understanding of the economics of carbon policy confirms, cash-for-clunkers is an incredibly inefficient way to lower carbon emissions; and as I hope I've established here, tallying every fuel dollar saved as a direct benefit of the bill is patently illogical.

It seems that this is a general phenomenon. For whatever reason, otherwise very smart non-economists are prone to bizarre lapses in critical thinking when the conversation turns to economic efficiency. And this is why—whatever our faults may be—economists will remain an important part of the policy discussion.


representativeagent said...

I wonder if the calculation for fuel savings takes into account the substitution effect. More fuel-efficient cars result in people driving more at the margin. This mitigates the intended effect. That is why a carbon tax or cap and traded is much more efficient.

Jowett said...

Arguably, Mattland passes are non-rival depending on the crowds. Perhaps Mattland should serve hotdogs individually or all-you-can-eat?

Matt Rognlie said...


Cindy Dy said...

Couldn't be written any better. Reading this post reminds me of my old room mate! He always kept talking about this. I will forward this article to him. Pretty sure he will have a good read. Thanks for sharing!