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July 24, 2006

Capitalism and Externalities

Regulation is essential to capitalism.  I’m damned near a libertarian and certainly a capitalist but I do believe SOME forms of targeted regulation are necessary – even though all regulation poses a danger.

Unregulated capitalism leads to passing off costs (externalities) on society as a whole.

Pollution is one good example.  If there is no law or regulation about dumping untreated waste in a stream or pouring smoke into the air, it’s gonna happen.  Even a corporation which wants to be a good citizen will find it impossible to compete if its competitors have a lower cost base because they are letting everyone else pay the cost of cleanup.

Some will argue that, in the days of the consumerism and the Internet, good corporate citizenship CAN be enforced by an informed marketplace.  I hope that happens but, so far, have seen marketplace regulation of externalities work only for fashionable social causes (won’t name names here) and fashion-dependant (non price-sensitive) products like branded athletic wear, coffee, and fat-enhanced ice cream.

Oil companies are happy to run TV campaigns touting their greenness and to experiment on the edges.  None of them would be able to unilaterally adopt a carbon dioxide neutral energy production process (assuming that’s a good idea) because the early adopter would be priced out of the market.

Regulation is no panacea.  Too often regulation is mainly for the benefit of the regulated: it keeps the upstart competition out.  Before the enormously successful deregulation of telephony in India, an old-school regulator told me that VoIP would never be allowed until it met all the quality standards of the PSTN (Public Switched Telephone System).  At that time 3% of Indians could afford to purchase this “quality”.  Untactfully, I asked if this meant “If you can’t afford a Cadillac, walk.  No Chevvies allowed.”  This policy did change (not because of my smart-ass response).  Now more than 10% of Indians have phones and the number is rising.  Most growth is in mobile where the voice quality is NOT as good as with fixed line.  But, on the other hand, fixed lines ain’t mobile and  take too long to provision.

Important point here is that even well-meaning regulators are likely to enforce the standards of obsolete technology.  Who’s to determine the trade-off between voice quality and mobility?  Price and quality?  This IS an area for consumer choice and NOT for regulation.

Product safety – especially when hazards are not easily discoverable – is a fit area for regulation.  Risk of injury can be an externality.  The alternative is the very blunt weapon of the liability suit and the class action bar.  But safety regulation, too, can become incumbent protection.  The Federal Communication Commission in the US, for example, insists that VoIP phones provide exactly the same kind of E911 service as landline phones.  This has acted to discourage the BETTER emergency services which could be provided on the Internet compared to the technologically primitive service available today on the PSTN.

Regulation doesn’t work at all when the government is the entity being regulated.  When the Iron Curtain lifted, it revealed an environmental disaster much greater than just Chernobyl.  The governments of the former socialist republics owned the industries they regulated.  They didn’t sacrifice their production goals to environmental externalities (to be polite).  One of the many good reasons for private ownership is to preserve an adversarial  relation between the regulators and the regulated.

A very good form of regulation is to force the externalities to become costs of production.  Tradable pollution credits really work to reduce pollution.  Why?  Because they are technology neutral and result specific.  Instead of leaving the good guys at a cost-disadvantage, they create an economic incentive to fix or avoid pollution.  Of course, the cost must be applied to ALL producers and that usually means some form of international cooperation.  That’s hard!  And that’s why the Kyoto treaty with its lofty goals and exclusion of huge developing economies can’t work.

It’s pretty clear (but not certain, sorry) that the rising production of carbon dioxide from burning fossil fuels IS an externality which can have a huge social cost.  Even the risk that anthropogenic carbon dioxide production causes serious global warming IS a cost.  Regulation which directly imposes that cost on ALL producers (easier to say than do), is an appropriate response.  Tradable credits, I think, would be the best way to do this based on our experience with pollution control.

Imposing this cost on the production use of fossil fuels WILL make their price go up.  We are already paying this cost, just not recognizing it.  Non-fossil forms of energy will become more competitive.  That’s good so long as all their significant externalities are also factored in.  For example, I’m a fan of building more nuclear plants.  But the cost of safely sequestering waste has to be part of the equation of nuclear power.

I hope that some day citizen journalism and an informed citizenry will make much government regulation unnecessary.  Right now, though, I think regulation of externalities is a legitimate and needed government function.  We still have to exert all our vigilance, though, to keep the regulators themselves honest and in check and out of the pockets of incumbents.

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