FIVE

COMPANIES NOT COVERING THEIR “SOCIAL COSTS”

Capitalism works best when there is perfect information and perfect mobility characterizing all of the market participants. A producer would know the costs of producing in different places and be free to move production to lower-cost areas. And consumers would know where the best-paying jobs are and be able to move to the best-paying jobs.

But information and mobility are far from perfect. Each producer and consumer has to bear the cost of information search and mobility. A move to another location for production or consumption would pay as long as the gross improvement in the producer’s or the consumer’s situation is larger than the costs borne for better information and better mobility.

One role of government is to help improve the business information available to producers, middlemen, and consumers. Governments carry out information censuses and samples about almost every industry, company, and product. Today, the Internet makes access to business knowledge quick and easy for both businesses and individuals.

Economists have worked on the theory of what makes an economy perfectly efficient. The economy is said to reach a “Pareto optimum” if no voluntary exchange of labor or capital or allocation of goods and services will make some people better off and other people worse off. Market failures exist when some market participants can be made better off without making others worse off.

Here are three types of market failure that can occur under capitalism. They are:

1. Businesses and consumers ignoring costs they cause for which they are not charged, which is called the problem of negative externalities
2. Public goods that are abused if not regulated or rationed, which is called the tragedy of the commons
3. Monopolistic or oligopolistic control of industries and markets, which is called the monopoly problem

COMPANIES AVOIDING SOCIAL COSTS

You might expect that a company involved in production would bear all the costs resulting from its activity. A steel company would pay for the iron ore, the electricity, equipment depreciation, employees’ wages, and so on. However, it is less likely that the steel company would be charged for the air pollution it caused or the water pollution from its chemicals that might have floated into the river. Air and water pollution are social costs that someone else may have to cover, either citizens who suffer from pollution or the government that might have to clean up the pollution and cover the health costs of victims.

The main point here is to identify the spillover effects of economic activity or processes that affect those who are not directly involved. Odors from a chemical factory can have negative spillover effects on the factory’s neighbors.

Total cost consists of private cost and social cost. The social cost is a “negative externality” in the production of steel. If the steel company was required to pay for this cost, it would have to raise its prices or be left with less money and produce less steel. By avoiding their social costs, companies price lower than they should and end up producing more output. Someone else has to pay for the pollution.

Because governments now have less money available to clean up pollution, it would be better to charge businesses for the pollution caused by their production arrangements. A charge would give each business an incentive to search for ways to reduce its level of carbon emission.

Two systems have been proposed. One is to put a tax on carbon emissions because carbon releases greenhouse gases into the atmosphere. Harvard economist Dale Jorgenson and his coauthors favor putting a tax on carbon.¹ The higher a company’s carbon emissions, the higher its tax bill. This will cause companies to reduce their carbon emissions.

Others have proposed a system that sets a limit on emissions, which is lowered over time if emissions decline. Each company estimates its carbon emission and needs to buy carbon credits. Suppose a business emits 100 tons of carbon each year and is required to buy enough carbon credits to cover 100 tons. The business later decides to buy pollution control equipment or switch from coal to lower pollution energy sources and manages to reduce its carbon emissions to 50 tons a year. Now it needs to buy only half as many carbon credits. If it had purchased carbon credits for 100 tons but now needs only 50, it can sell the 50 surplus carbon credits either to another business that needs them to cover its polluting costs, or on a spot market at the market price. Such a system is called a cap-and-trade system. The government puts a cap on how much pollution can be tolerated, and companies can buy and sell carbon credits to cover the cost of the pollution they emit. Their carbon credit costs will lead them to search for ways to reduce their emissions. Through emission trading, companies will be acting more responsibly about air pollution.

The question is how fast should the cap level be reduced? Many have favored lowering the cap at a rate to limit the earth’s temperature from rising more than two degrees Centigrade. But this rate is not universally accepted, and some countries may not join in this cap-and-trade system. One suggestion is to put “carbon tariffs” on imported goods coming from nonparticipating countries, an idea disliked by the World Trade Organization. The question is, do we prefer to save the planet or continue to practice “free trade”?

As for controlling water pollution, the government would state what can and cannot be dropped into water and set penalties for such pollution. If the penalties are sufficiently high, the polluter would need to find some other way to dispose of bad chemicals.

Negative externalities also occur on the consumption side, not just the production side. The behavior of consumers can create negative externalities. Smokers pass on toxic harm to nonsmokers in the same room. People who litter on streets and in parks are imposing a cleanup cost on society. Car owners who buy high-pollution cars or do a lot of driving add to the pollution level. Consumers who prefer products that come from distant lands cause extra pollution because of all the extra fuel consumed in long-distance transportation.

In these cases, the government can pass laws to reduce some of these negative externalities. Government usually charges a higher registration license on cars that emit more pollution. Government places a high tax on cigarettes and encourages nonsmoking signs in offices and public transportation to protect citizens from the harmful effects of secondary smoke.

It must be recognized that producers and consumers can also generate positive externalities. A company that spends money on training its employees creates a benefit that goes beyond the benefit to itself in that the workers are more educated. One can imagine a case where a company claims to have created a set of positive benefits and proposes that they offset the negative externalities. Wal-Mart could claim that its ability to offer consumers low prices and its employees training offsets the argument against the low wages it pays.

Negative externalities are found in systems other than capitalism. Fortunately, capitalism has found a way to handle them using the market system itself to reduce or lower these negative externalities.

PROTECTING PUBLIC GOODS

I’ve discussed how owners of private goods may have to cover social costs connected with the use of these goods. Now let’s turn to public goods that are owned and valued by the public. I’m thinking of parks, rivers, lakes, and forests. I believe it’s necessary for government to put limits on the use of public goods to protect their quality.

A standard illustration is the grazing land for sheep. Suppose there are two sheep owners, and each lets his sheep graze on his land. Suppose there is another stretch of land that is public land located between the two sheep owners’ properties. A sheep owner would be better off using the public land for grazing than his own land. Both sheep owners would see this as an opportunity and bring their sheep to graze on the public land first. The result would be overgrazing, and soon the public land would not grow enough grass for grazing. Only then would the two sheep owners bring their sheep to graze on their own private land.

The same problem would happen with forests or the sea if they are not protected. Too much timber would be cut or overfishing would lead to the disappearance of certain fish.

To prevent the tragedy of the commons, two solutions are available. One is to issue a set of rules for citizens who want to make use of the public good. A public park might issue rules: It is open only from 9 a.m. to 6 p.m.; dogs are not allowed to relieve themselves unless the owner carries a poop bag; littering is prohibited and punishable by a fine; no campfires are permitted.

The other solution is issuing permits to prevent the overuse of a public good. The government decides on how much use can be made of a public good and issues hunting and fishing permits. Some national parks that are overcrowded limit the number of visitors per day.

Many places in the world need to limit the use of water where water is scarce. India uses half of the world’s water and doesn’t use it efficiently. It could learn the drip method in agriculture used in Israel, also short of water, which is ten times more efficient. Governments can consider a number of measures. The price of water can be raised. People can be encouraged to shower or bathe less often and to water their lawns less often. The government can issue caps on industry and farmers’ use of water. The government can prevent oil and gas hydraulic fracturing (or fracking, for short), which uses an excessive amount of water.

MONOPOLIES AND BARRIERS TO ENTRY

The purpose of a capitalist economy is to rely on open and free competition to set prices and outputs. If one company or industry is earning high profits, other companies need to be free to compete by offering lower prices or better products. Healthy competition keeps market prices and profits from becoming excessive. This assumes that there are no barriers to entry.

The fact is that many barriers can exist to prevent a competitor from entering an attractive market. Such barriers protect incumbent firms and restrict competition in a market. They represent a cost of entry that the new firm must bear, but not the firms already existing in the industry. They prevent a socially beneficial result from happening that would increase output and lower price.

Among the most prominent barriers to entry are:

• Legal Barriers. Zoning laws or transport agreements can prevent entry; other examples are protective tariffs on imports; switching barriers, such as long-term contracts making it expensive to change to a new competitor; the lack of essential resources needed for production; and the ownership of patents that prevent the entering firm from gaining access to necessary technology.
• Cost Barriers. They include the high cost of required advertising to establish the new brand; the high cost of required capital; the high cost of attracting distributors and suppliers when there are exclusive agreements; the low possibility of achieving scale to bring down cost to the level enjoyed by the present industry leaders; the high cost of obtaining the necessary licenses and permits; the high cost of dealing with predatory pricing by the dominant firm to stop entry; and the high cost of research and development (R&D).

All of these factors perpetuate the dominant firms’ leadership in the market. The leading firms work hard to prevent the entry of new firms or the rise of existing minor firms. The leaders develop a strong brand and loyal customers who are willing to pay more.

The extreme anticompetitive case is where a monopoly exists—namely, one seller of an important good or service where near substitutes don’t exist. Sometime this may be a natural monopoly, where a firm’s per-unit cost decreases as it increases output and where one firm is most efficient from a cost perspective. Here the government may decide that it would be inefficient to have more than one firm supply the nation’s electricity or telecommunications or oil. That monopoly might be operated by the state or by a private enterprise whose pricing and investment activities are regulated in a way to prevent excessive profits. The worst case is where a private monopoly exists that has given favors to government parties in return for installing barriers preventing any competitor from appearing.

There can also be an oligopoly of a few dominant firms that agree to price in a certain way and control output, following cartel-like principles. Cartels are found in such industries as oil, electricity, and telecommunications. They result in higher prices and reduced outputs. Another problem with oligopolies is the standardization of products and services, which ignores many buyers who want product and service variations.

Edmund S. Phelps, a professor of economics at Columbia University and a Nobel laureate, reports a troubling trend in many countries that he calls “corporatism,” in which economic activity is controlled by large interest groups. When corporatism becomes dominant in a society, the public doesn’t adequately appreciate the contributions of individuals who work hard to innovate. A corporatist economy can grow for a while, but it will not produce the needed growth that an entrepreneurial culture can deliver. The overconcentration of power in a small number of huge companies can lead to another type of market failure.

Even though dominant firms are in a good position to protect and perpetuate their dominance, other factors may finally end their dominance. A major one is the emergence of a new technology that is superior to the old technology. Kodak, which was unrivaled in the film business for a hundred years, lost its dominance with the rise of digital cameras that don’t use film. Technological disruption often brings about lower prices that the dominant firm, so heavily invested in the old technology, can’t match and where the cost of redesigning its whole business is prohibitively high. Besides technology breakthroughs, new competitors may win by launching a clever advertising campaign, or creating a substantially better product, or patenting something new. So in addition to possible government interventions to erase market failure, many other forces may come into play to correct a monopolistic situation.

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The existence of market failure is the reason for government intervention in a particular market. The aim is to find a possible means of correction. However, some regulations and types of interventions involving taxes, subsidies, bailouts, and wage and price controls may possibly lead to an inefficient allocation of resources, sometimes called government failure. This occurs when the cost of intervention exceeds the cost of correction. Usually political parties split on the issue of whether an intervention has improved on an inefficient market outcome or made it worse.

Market failures are a very common problem in a free market system. Conservative economists, such as the late Milton Friedman from the University of Chicago, argue that a market failure does not necessarily imply that government should attempt to solve the problem, because the costs of “government failure” might be worse than those of the market failure. Liberal economists feel that government should ensure efficiency and social justice through interventions or introduce market-oriented solutions.