The Economics of Climate Change


The most commonly used justification for engaging in a free market economy is that free markets allocate scarce resources most efficiently. That is, in a free market there is the least amount of wasted resources when compared to other more restrictive or interventionist economies. Simply put, efficiency is another way of saying that free markets are, in the long run, more productive than other market and non-market systems. A term that is loosely analogous to free markets is capitalism.

What is productivity and how is it measured? Productivity can be expressed as the ratio of outputs to inputs in the production process, i.e. output per unit of input. When all outputs and all inputs are included in this calculation, the result is called total productivity. And historically, free markets have tended to win the productivity challenge hands down.

Hang in there. This post will get more relevant and interesting soon. Promise.

If scarce resources are allocated more efficiently and there’s less waste, the productive process should be more profitable. And if it’s more profitable, it stands to reason that, when all is said and done, there should be more resources left over for other purposes, such as investment and wages and benefits, etc.

So far so good. The efficiency argument only holds true, however, if two criteria are met. The first criteria is that in order for the productivity calculation to be correct all inputs (all costs), such as labor and raw materials, and externalities (we’ll get to externalities in a minute) must be included in the equation. If some of the costs are not included then the productivity ratio will be skewed and, as a result, the market seem somewhat more productive than first thought.

The second criteria has to do with those “left over resources” mentioned above. Left over resources, which can be used for investment and wages and benefits, are only available if they are not otherwise siphoned-off or sequestered outside of the productive process. That is, if the left over resources (profits) are removed from the productive process and taken away from their intended purpose (again investment, wages, benefits) then the whole value of efficiency gets thwarted and the free market system becomes little better than an economic system run by a dictator or a tyrant.

Now here comes the good part.

So what does this have to do with climate change? Well, some will argue that if smokestacks and CO2 emissions and miles-per-gallon requirements, etc. are regulated by government (the antithesis of free markets), productive profits will be negatively impacted such that jobs (an input) will have to be cut and wages (another input) will have to be lowered and benefits (yet another input) will have to be decreased. Because after all, if your unregulated output of 100 divided by an unregulated input of 50 (equals a productivity ratio of 2.0) is changed to 100 divided by 60 (the additional cost of the regulations) your productivity ratio will only be 1.67. Ergo, in order to maintain your profit margin you have to cut jobs, wages etc.


However – way back in the fifth paragraph, two criteria were mentioned. The first specified that all input costs in the productive process had to be included in order for the productivity ratio to hold water. The fact of the matter is that very rarely are all of the costs rolled into the formula. For example, although labor and raw materials are always accounted for, what about the cost of maintaining the roads and bridges that a company’s trucks utilize to ship in the materials and ship out its finished goods. Or how about pollution and other health related problems that are a result of the productive process?

Costs which are viewed by producers as external to their business are called externalities and the free market generally ignores the existence of external costs. After all, a productivity ratio of 1.67 doesn’t look as good as a ratio of 2.0 to stockholders and the Board of Directors.

New childhood asthma cases (and the social cost of treating them) have skyrocketed over the past twenty years largely because of industrial air pollution, but this and many other social costs are not recognized by corporate America. So, if we were honest with ourselves we know that the productivity ratios (and thus the profits) touted by corporate executives are purposely inflated. Why? Because profit estimates drive stock prices and executive pay and bonuses are based on ever-increasing stock prices.

Wait for it!

And last, but not least, is the second criteria mentioned in paragraph five. To what extent have the rewards of capitalism and the efficient free market been siphoned-off and sequestered for the benefit of the few (today we call it the 1%) instead of being used to pay for the true costs of the productive process? Does an executive making 15 or 30 or 45 million dollars a year really have to cut the wages or the jobs of workers making $35,000 a year (possibly .001 percent of one executive paycheck) in order to have the funds to pony up the company’s fair share of its external costs?

Which brings me all the way back to the topic of this piece. If nothing else, life is a series of trade-offs. Climate change is the granddaddy of all externalities. Do we really need the threat of job cuts preventing us from finding a solution before floods or hurricanes or droughts or tornados or extinction-level-events wipe us all out? In corporate America something’s got to change. We can either continue to reward a select few with unconscionable wealth or we can acknowledge the true cost of doing business and finally pay the piper for all the externalities.

Who has a better idea?

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