Chapter 7 Market Failures: External Costs And Benefits 10 of meeting the limit of two units is shown in the lower half of Table 7.1. Firm A incurs the relatively modest cost of $700 ($100 + $200 + $400). But firm B must pay $2,600 ($200 + $600 + $1,800). The total cost to all firms is $13,500. What if the EPA adopts a different strategy and sells rights to pollute? Such rights can be thought of as tickets that authorize firms to dump a unit of waste into the atmosphere. The more tickets a firm purchases, the more waste it can dump, and the more cleanup costs it can avoid. TABLE 7.1 Costs of Reducing Sulfur Dioxide Emissions A B C D E Marginal cost of eliminating each unit of pollution: First unit $ 100 $ 200 $ 200 $ 600 $1,000 Second unit 200 600 400 1,000 2,000 Third unit 400 1,800 600 1,400 3,000 Fourth unit 800 5,400 800 1,800 4,000 Fifth unit 1,600 16,200 1,000 2,200 5,000 Cost of Reducing Pollution by Cost of Reducing Pollution by Establishment of Government Standards Sale of Pollution Rights Cost to A of eliminating 3 units $ 700 Cost to A of eliminating 4 units $1,500 Cost to B of eliminating 3 units 2,600 Cost to B of eliminating 2 units 800 Cost to C of eliminating 3 units 1,200 Cost to C of eliminating 5 units 3,000 Cost to D of eliminating 3 units 3,000 Cost to D of eliminating 3 units 3,000 Cost to E of eliminating 3 units 6,000 Cost to E of eliminating 1 unit 1,000 Total cost of five units $13,500 Total cost of five units $9,300 Remember that the EPA can control the number of tickets it sells. To limit pollution to the maximum acceptable level of ten units, all it needs to do is sell no more than ten tickets. Either way, whether by pollution standards or rights, the level of pollution is kept down to ten units, but the pollution rights method allows firms that want to avoid the cost of a cleanup to bid for tickets. The potential market for such rights can be illustrated by conventional supply and demand curves, as in Figure 7.5. The supply curve is determined by EPA policymakers, who limit the number of tickets to ten. Because in this example the supply is fixed, the supply curve must be vertical (perfectly inelastic). Whatever the price, the number of pollution rights remains the same. The demand curve is derived from the costs firms must bear to clean up their emissions. The higher the cost of the cleanup, the more Chapter 7 Market Failures: External Costs And Benefits 11 attractive pollution rights will be. As with all demand curves, price and quantity are inversely related. The lower the price of pollution rights, the higher the quantity demanded. Figure 7.5 Market for Pollution Rights Reducing pollution is costly (see Table 7.1). It adds to the costs of production, increasing product prices and reducing the quantities of products demanded. Therefore firms have a demand for the right to void pollution abatement costs. The lower the price of such rights, the greater the quantity of rights that firms will demand (see Table 18,2). If the government fixes the supply of rights at ten and sells those ten rights to the highest bidders, the price of the rights will settle at the intersection of the supply and demand curves -- here, $1,500. Table 7.2 shows the total quantity demanded by the firms at various prices. At a price of zero, the firms want twenty-five rights (five each). At a price of $201, they demand only twenty-one. A wants only three, for it will cost less to clean up its first two units (at costs of $100 and $200) than to buy rights to emit them at a price of $201. B wants four rights, for its cleanup costs are higher. Given the information in the table, the market clearing price—the price at which the quantity of property rights demanded exactly equals the number of rights for sale— will be something over $1,400—say $1,500. Who will buy those rights, and what will the cost of the program be? At a price of $1,500 per ticket, firm A will buy one and only one ticket. At that price, it is cheaper for the firm to clean up its first four units (the cost of the cleanup is $100 + $200 + $400 + $800). Only the fifth unit, which would cost $1,600 to clean up, makes the purchase of a $1,500 ticket worthwhile. Similarly, firm B will buy three tickets, firm C none, firm D two, and firm E four. The cost of any cleanup must be measured by the value of the resources that go into it. The value of the resources is approximated by the firm’s expenditures on the cleanup—not by their expenditures on pollution tickets. (The tickets do not represent real resources, but a transfer of purchasing power from the firms to the government.) Accordingly, the economic cost of reducing pollution to ten units is $9,300; $1,500 for firm A. $800 for B, $3,000 each for C and D, and $1,000 for E. This figure is Chapter 7 Market Failures: External Costs And Benefits 12 significantly less than the $13,500 cost of the cleanup when each firm is required to eliminate three units of pollution. Yet in each case, fifteen units are eliminated. In shirt, the pricing system is more economical—more cost-effective or efficient—than setting standards. Because it is more efficient, it is also the more economical way of producing goods and services. More resources go into production and less into cleanup. TABLE 7.2 Demand for Property Rights Price Quantity Price Quantity $ 0 25 $1,601 9 101 24 1,801 7 201 21 2,001 6 401 19 2,201 5 601 16 3,001 4 801 14 4,001 3 1,001 11 5,001 2 1,401 10 5,601 0 The idea of selling rights to pollute may not sound attractive, but it makes sense economically. When the government sets standards, it is giving away rights to pollute. In our example, telling each firm that it must reduce its sulfur dioxide emissions by three units is effectively giving them each permission to dump two units into the atmosphere. One might ask whether the government should be giving away rights to the atmosphere, which has many other uses besides the absorption of pollution. Though some pollution may be necessary to continued production, that is no argument for giving away pollution rights. Land is needed in may production processes, but the Forest Service does not give away the rights to public lands. When pollution rights are sold, on the other hand, potential users can express the relative values they place on the right to pollute. 2 In that way, rights can be assigned to their most valuable and productive uses. MANAGER’S CORNER: How Honesty Pays in Business There exist the popular perception that markets fail because business is full of dishonest scoundrels – especially high ranking executives -- who cheat, lie, steal, and worse to increase their profits. This perception is reflected in and reinforced by the way business people are depicted in the media. According to one study, during the 1980s almost 90 percent of all business characters on television were portrayed as corrupt. 3 No one can 2 Note that the system allows environmental group as well as producers to express the value they place on property rights. If environmental groups think ten units of sulfur dioxide is too much pollution, they can buy some of the tickets themselves and then not exercise their right to pollute. 3 See page 146 of Robert Lichter, Linda Lichter, and Stanley Rothman, Watching America (New York: Prentice Hall, 1990). Chapter 7 Market Failures: External Costs And Benefits 13 deny that people in business have done all kinds of nasty things for a buck. But the impression of pervasive dishonest business people is greatly exaggerated. Business people are no more likely to behave dishonestly than other people. In fact, there are reasons to believe that business people might be more honest than the typical American on the street. Moreover, there are ways business people can commit themselves to incentive arrangements that motivate honest behavior in ways that their customers find convincing. The Role of Honesty in Business The case to be made for honesty in business is not based on any claim that business people are particularly virtuous, or ethical to the core of their beings. We can make no claim to keen insights into the virtue of business people or anyone else. We might even be persuaded that business people have less virtue on average than do those who choose more caring occupations, such as teachers, social workers, missionaries, and nurses. But we do claim to know one simple fact about human behavior, and that is people respond to incentives in fairly predictable ways. In particular, the lower the personal cost of dishonesty, the greater the extent of dishonestly within most identified groups of people. If business people act honestly to an unusual degree (or different from what other people in other situations do), it must be in part because they expect to pay a high price for be- having dishonestly. This is, in fact, the case because business people have found, some- what paradoxically, that they can increase profits by accepting institutional and contractual arrangements that impose large losses on them if they are dishonest. Though seldom mentioned, most business activity requires a high degree of honest behavior. If business is going to be conducted at any but the simplest level, products must be represented honestly, promises must be kept, costly commitments must be made, and business people must cooperate with each other to take the interests of others, particularly consumers, into consideration. Indeed, if the proverbial man from Mars came down and observed business activity, he might very well conclude that business people are extraordinarily honest, trusting, and cooperative. They sell precious gems that really are precious to customers who cannot tell the difference between a dia- mond and cut glass. They promise not to raise the price of a product once customers make investments that make switching to another product costly, and they typically keep the promise. They make good faith pledges that the businesses they own, but are about to sell, will continue to give their customers good service. They commit themselves to costly investments to serve customers knowing the investments will become worthless if customers shift their business elsewhere. The way business people behave in the marketplace suggests a level of morality that is at variance with the self-interest that economists assume, in their theoretical models, motivates business activity. Some argue that the economist’s assumption of self interest is extreme, and we recognize that many people, including many business people, behave honestly simply because they feel it is the right thing to do. But few would recommend that we blindly trust in the honesty of others when engaged in business activity. The person who is foolish enough to assume that all business people are honest Chapter 7 Market Failures: External Costs And Benefits 14 and trustworthy only has to encounter a few who are not to find himself separated quickly from his wealth. Is there a contradiction here between the honesty that characterizes most business activity and the fact that business people are not generally assumed to be honest? The answer is no. Indeed, the reason business people generally behave honestly is best explained by the fact that it would be foolish to assume that they are honest. And many business people are honest precisely because others assume they won’t be. It is easy to imagine a situation in which business people can profit at the expense of their customers, workers, and others with whom they deal if they behave deceitfully. For example, the quality of many products (say used cars or diamonds) is difficult for consumers to easily determine. The seller who takes advantage of this by charging a high quality price for a low quality product would capture extra profits from the sale. A business owner who is about to retire can profit by making promises not to be fulfilled until after his retirement, and which he does not plan to keep. The monopoly producer of a superior product (but one which requires the consumer to make costly investments in order to use it) can offer the product at a low price and then, once the consumer becomes dependent on it, increase the price significantly. Other examples of the potential profit from dishonest behavior are easily imagined. In fact, such examples are about the only type of behavior some people ever associate with business. Again, we want to emphasize that dishonest behavior of the above type does occur. But such dishonest behavior is the exception, not the rule of much business, despite the story-telling talents of Hollywood writers. The reason is that in addition to being a virtue from a strictly moral perspective, honesty is also important for quite materialistic reasons. An economy in which people deal with each other honestly can produce more wealth than one in which people are chronically dishonest. So there are gains to be realized from honesty, and when there are gains to be captured there are people who, given the opportunities available in market economies, will devise ways to capture them. A businessperson who attempts to profit from dishonest dealing faces the fact that few people are naively trusting. It may be possible to profit from dishonesty in the short run, but those who do so find it increasingly difficult to get people to deal with them in the long run. And in some businesses it is extremely difficult to profit from dishonesty even in the short run. How many people, for example, would pay full price for a “genuine” Rolex watch, or diamond necklace, from someone selling them out of a Volks- wagen van at the curb of a busy street? Without being able to provide some assurance of honesty, the opportunities to profit in business are very limited. So business people have a strong motivation to put themselves in situations in which dishonest behavior is penalized. Only by doing so can they provide potential customers, workers, and investors with the assurance of honest dealing required if they are to become actual customers, workers, and investors. The advantage of honesty in business can be illustrated by considering the problem facing Mary who has a well-maintained 1990 Honda Accord that she is willing to sell for as little as $4,000. If interested buyers know how well maintained the car is, Chapter 7 Market Failures: External Costs And Benefits 15 they would be willing to pay as much as $5,000 for it. Therefore, it looks like it should be possible for a wealth-increasing exchange to take place since any price between $4,000 and $5,000 will result in the car being transferred to someone who values it more than the existing owner. But there is a problem. Many owners of 1990 Honda Accords who are selling their cars are doing so because their cars have not been well and are about to experience serious mechanical problems. More precisely, assume that that 75 percent of the 1990 Honda Accords being sold are in such poor condition that the most a fully informed buyer would be willing to pay for them is $3,000, with the other 25 percent worth $5,000. This means that a buyer with no information on the condition of a car for sale would expect a 1990 Honda Accord to be worth, on average, only $3,500. But if buyers are willing to pay $3,500 for a 1990 Accord, many of the sellers whose cars are in good condition will refuse to sell, as is the case with Mary who is unwilling to sell for less than $4,000. So the mix of 1990 Accords for sale will tilt more in the direction of poorly maintained cars, their expected value will decline, and even fewer well-maintained 1990 Accords will be sold. This situation is often described as a market for “lemons,” and illustrates the value of sellers being able to commit themselves to honesty. 4 If Mary could somehow convince potential buyers of her honesty when she claims her Accord is in good condition, she would be better off, and so would those who are looking for a good used car. The advantage of being able to commit to honesty in business extends to any situation where it is difficult for buyers to determine the quality of products they are buying. The advantages of honesty in business and the problem of trying to provide credible assurances of that honesty can also be illustrated as a game. In Figure 7.6, we present a payoff matrix for a buyer and a seller giving the consequences from different choice combinations. The first number in the brackets gives the payoff to the seller and the second number gives the payoff to the buyer. If the seller is honest (the quality of the product is as high as he claims) and the buyer trusts the seller (she pays the high-quality price), then both realize a payoff of 100. On the other hand, if the seller is honest but the buyer does not trust him, then no exchange takes place and both receive a payoff of zero. If the seller is dishonest while the buyer is trusting, then the seller captures a payoff of 150, while the buyer gets the sucker’s payoff of -50. Finally, if the seller is dishonest and the buyer does not trust him, then an exchange takes place with the buyer paying a low quality price but getting a lower quality product than she would be willing to pay for, with both the seller and buyer receiving a payoff of 25. From a joint perspective, honesty and trust are the best choices since this combination results in more wealth for the two to share. But this will not be the outcome, given the incentives created by the payoffs in Figure 7.6. The buyer will not trust the seller. The buyer knows that if her trust of the seller is taken for granted by the seller then he would attempt to capture the largest possible payoff from acting dishonestly. On the other hand, if he believes she does not trust him his highest payoff is still realized by acting dishonestly. So she will reasonably 4 The general problem of “lemons” is discussed by George A. Akerlof, “The Market for Lemons: Qualitative Uncertainty and the Market Mechanism,” Quarterly Journal of Economics, Vol. 84 (1970): 488- 500. Chapter 7 Market Failures: External Costs And Benefits 16 expect the seller to act dishonestly. This is a self-fulfilling expectation since when the seller doesn’t expect to be trusted, his best response is to act dishonestly. Figure 7.6 The Problem of Trust in Business BUYER Trust Doesn’t Trust Honest (100, 100) (0, 0) SELLER Dishonest (150, -50) (25, 25) The seller would clearly be better off in this situation (and so would the buyer) if he somehow created an arrangement that reduced the payoff he could realize from acting dishonestly. If, for example, the seller arranged it so he received a payoff of only 50 from acting dishonestly when the buyer trusted him, as is shown in Figure 7.7, then the buyer (assuming she knows of the arrangement) can trust the seller to respond honestly to her commitment to buy. The seller’s commitment to honesty allows both seller and buy- er to each realize a payoff of 100 rather than the 25 they each receive without the commitment. But how can a seller commit him or herself to honesty in a way that is convincing to buyers? What kind of arrangements can sellers establish that penalize them if they attempt to profit through dishonesty at the expense of customers? There are many business arrangements, and practices, that can cause sellers to commit to honest dealings. We will briefly consider some of them here. The arrange- ments are varied, as one would expect, since the ways a seller could otherwise profit from dishonest activity are also varied. Notice that our discussion of the situation described in Figure 7.6 implicitly assumes that the buyer and seller deal with each other only one time. This is clearly a situation in which the temptation for the seller to cheat the buyer is the strongest, since the immediate gain from dishonesty will not be offset by a loss of future business from a mistreated buyer. If a significant amount of repeat business is possible, then the temp- tation to cheat decreases, and may disappear. What the seller gains from dishonest dealing on the first sale can be more than offset by the loss of repeat sales. So, one way sellers can attempt to move from the situation described in Figure 7.6 to the one de- scribed in Figure 7.7 is by demonstrating that they are in business for the long run. For example, selling out of a permanent building with the seller’s name or logo on it, rather than a Volkswagen van, informs potential customers that the seller has been (or plans on being) around for a long time. Sellers commonly advertise how long they have been in business (for example, “Since 1942” is added under the business name), to inform people that they have a history of honest dealing (or otherwise they would have been out of business long ago) and plan on remaining in business. Chapter 7 Market Failures: External Costs And Benefits 17 As we have seen, however, in our discussion of “the last period problem,” the advantages motivated by repeated encounters tend to break down if it is known that the encounters will come to an end at a specified date. For this reason firms will attempt to maintain continuity beyond what would seem to be a natural end-period. Single proprietorships, for example, would seem to be less trustworthy when the owner is about to retire, or sell. But, as discussed earlier, a common way of reducing this problem is for the owner’s offspring to join the business (“Samson and Sons” or “Delilah and Daugh- ters”) and ensure continuity after their parent’s retirement. Indeed, even though large corporations have lives that extend far beyond that of any of their managers, they often depend on single proprietorships to represent and sell their products. As indicated earlier in the book with our example of Caterpillar, the heavy equipment company, it is common for such corporations to have programs to encourage the sons and daughters of these sin- gle proprietors to follow in their parents’ footsteps. Figure 7.7 The Problem of Trust in Business, Again BUYER Trust Doesn’t Trust Honest (100, 100) (0, 0) SELLER Dishonest (50, -50) (25, 25) The advantage of letting people know that you have been, and are planning to be, in business a long time is that it informs them that you have something to lose –potential future business -- if you engage in dishonest dealing. In effect, you are providing poten- tial customers with a hostage, something of value that one party to a contract (the customer) can destroy if the other party (seller) does not keep its promises. There are numerous other ways that businesses create arrangements to provide hostages in ways that make their commitments to honest dealing credible. Before examining some of these arrangements, however, it is important to consider an important feature that hostages should have. The use of hostages has a long history, and is traditionally thought of as a way to reduce the likelihood of hostilities between two countries or kingdoms. For example, if King A intended to wage war on Kingdom C and wanted to keep Kingdom B neutral, he could assure King B of his good faith by yielding up his beloved daughter to King B as a hostage. Assuming King A really did love his daughter, he would then be very reluctant to break his promise and invade Kingdom B after conquering Kingdom C. But even if King A does have a compelling incentive not to wage war against King B as long as his daughter is King B’s hostage, a potential problem remains. King B may find the daughter so attractive that he values her more than her father’s promise not to invade. Therefore, King B may decide to join with Kingdom C against King A and keep the daughter for himself. This suggests that an ugly daughter (one only a father could love!) makes a better hostage than a beautiful daughter. Chapter 7 Market Failures: External Costs And Benefits 18 The general proposition that comes from this example is that the best hostage is one that the person giving it up values highly and which the person receiving it values not at all. The example also suggests that sometimes it is best, particularly if the hostage is valuable to the person holding it, for the parties to exchange hostages. For example, if King A only has beautiful daughters then the best arrangement may be for him to ex- change a beautiful daughter for one of King B’s handsome sons (presumably for Queen A’s keeping). Of course, it is now important that King B values his son more than he does King A’s daughter and that Queen A values her daughter more than she does King B’s son. A firm’s reputation can be thought of as a hostage that the firm puts in the hands of its customers as assurance that it is committed to honest dealing. A firm’s reputation is an ideal hostage because it is valuable to the firm, but has no value to customers apart from its ability to ensure honesty. A firm has a motivation to remain honest in order to prevent its reputation from being destroyed by customer dissatisfaction, but customers cannot capture the value of the reputation for themselves. The more a firm can show that it values its reputation, the better hostage it makes. Consider the value of a logo to a firm. Companies commonly spend what seems an enormous amount of money for logos to identify them to the public. Well-known artists are paid handsomely to produce designs that do not seem any more attractive than those that could be rendered by lesser-known artists (many of whose artistic efforts have never gone beyond bathroom walls). Furthermore, companies are seldom shy about publicizing the high costs of their logos. It may seem wasteful for a company to spend so much for a logo, and silly to let consumers know about the waste (the cost of which ends up in the price of its products). But expensive logos make sense when we recognize that much of the value of a com- pany’s logo depends on its cost. The more expensive a company’s logo, the more that company has to lose if it engages in business practices that harm its reputation with consumers, a reputation embodied in the company logo. The company that spends a lot on its logo is effectively giving consumers a hostage that is very valuable to the company. Consumers have no interest in the logo except as an indication of the company’s commit- ment to honest dealing, but will not hesitate to destroy the value of the logo (hostage) if the company fails to live up to that commitment. Expensive logos are an example of how businesses make non-salvageable investments to penalize themselves if they engage in dishonest dealing. Such investments are particularly common when the quality of the product is difficult for consumers to determine. The products sold in jewelry stores, for example, can vary tremendously and few consumers can judge that value themselves. Those jewelry stores that carry the more expensive products want to be convincing when they tell customers that those products are worth the prices being charged. One way of doing this is by selling jewelry in stores with expensive fixtures that would be difficult to use in other locations: ornate chandeliers, unusually shaped display cases, expensive counter tops, and generous floor space. What could the store do with this stuff if it went out of business? Not much, and this tells the customers that the store has a lot to lose by misrepresenting Chapter 7 Market Failures: External Costs And Benefits 19 its merchandise to capture short-run profits. Non-salvageable investments serve as hostages that sellers put into the hands of customers. Another rather subtle way that sellers use “hostages” to provide assurances of honesty is by letting consumers know that they (the sellers) are making lots of money. If it is known that a business is making a lot more profit from its existing activity than it could make in alternative activities, consumers will have more confidence that the busi- ness won’t risk that profit with misleading claims. The extra profits of the business are a hostage that will be destroyed by consumers’ choices if the business begins employing dishonest practices. 5 Expensive logos and non-salvageable capital are not only hostages in themselves, they also inform consumers that the firm is making enough money to afford such extravagances. Expensive advertising campaigns, often using well-known celebrities, also serve the same purpose. Through expensive advertising, a company is doing more than informing potential customers about the availability of the product; it is letting them know that it has a lot of profits to lose by misrepresenting the quality of the product. 6 The idea of firms intentionally making their profits vulnerable to the actions of others may seem inconsistent with our discussion on “make-or-buy” decisions. In that early chapter we argued that firms often forgo the advantages of buying inputs in the marketplace by making them in-house to protect their profits on their investment against exploitation by others. The difference in the two cases is important. When firms put their profits at risk as a hostage to consumers, those consumers cannot capture the profits for themselves. They can only destroy them, and their only motivation for doing so would be that the firm is no longer satisfying their demands. In the case where a firm incurs the disadvantage of producing in-house to protect its profits, the problem is that suppliers can actually capture those profits for themselves by acting opportunistically, or dishonestly. So in some cases protecting profits promotes honest dealing, and in other cases putting those profits at risk promotes honest dealing. The importance business people attach to committing themselves to honesty sometimes leads them to put their profits in a position to be competed away by other firms that will benefit from doing so. Consider a situation where a firm has a patent on a high quality product that consumers would like to purchase at the advertised price, but a product that would be difficult to stop using because its use requires costly commitments. The fear of the potential buyers is that the seller will exploit the long-term patent 5 Technically speaking, the “extra profit” we have in mind is dubbed “quasirents” by economists, and quasirents are the returns that can be made off a fixed investment over and above what can be earned elsewhere. These profits, or quasirents, can be extracted by opportunistic behavior because the investment’s value is lower in some other activity. We use the term “profit” here and elsewhere because it is more familiar to general business readers and because the terms “rent” (or “quasirents”) might be confused with the monthly payments businesses make for the use of their buildings. 6 A number of years ago, one of the major pantyhose companies hired the famous football player, Joe Namath, to advertise their pantyhose by claiming that they were his favorite brand. This was surely not done to convince the public that Joe Namath actually wore a particular brand of pantyhose, or any pantyhose for that matter. A more plausible explanation is that the company wanted an advertisement that would get the public’s attention and let people know that they were making enough money in the pantyhose business to hire Joe Namath, who was a very expensive spokesman at the time. . reducing pollution to ten units is $9,300; $1,500 for firm A. $800 for B, $3,000 each for C and D, and $1,000 for E. This figure is Chapter 7 Market Failures:. a fully informed buyer would be willing to pay for them is $3,000, with the other 25 percent worth $5,000. This means that a buyer with no information