Wednesday, April 10, 2019
THE THEORY OF THE SECOND BEST. SOME INCONVENIENT TRUTHS.
What sometimes seem like complex abstractions lead to some clear and important real world conundrums.
There is a well-known principle in economics, the theory of the second best, which calls into question the neo-liberal paradigm of reliance on free markets alone to produce the best or even reasonably satisfactory outcomes without external intervention. The impeccable logic of the theory tells us that in a complex system (such as any modern economy), a serious market failure in one part, such as failure to tax greenhouse gas emissions or to develop cost reflective retail tariffs, can change the rules of the game in a disturbing way. Policies normally assumed to be fundamental necessities of a market economy, such as competition policy, can then actually make things worse. The subject is most often discussed in relation to international trade, but the energy sector also provides many examples. We need to recognise them and address the underlying issues.
The perfectly competitive idealisation of the market economy, the neo-liberal paradigm, leads in equilibrium to an efficient allocation of resources and a socially optimum outcome. This philosophy is based on elegant mathematical and logical proofs of the wisdom of the invisible hand, but the proofs depend in turn on important assumptions about the nature of the real world which the theory is intended to describe. Recognition of the questionable nature of many of these assumptions leads in turn to many of the complexities of policy making often discussed in this blog. This piece is intended only as a simple and brief “umbrella” exposition of some general ideas about the nature and implications of market failure.
A recognised glitch in the philosophy of the neo-liberal paradigm is known as “the theory of the second best.” It qualifies the presumption for unfettered markets with the caveat that as soon as you’re dealing with an imperfect world, then there is no guarantee that taking away any single distortion will make things better, rather than worse. In terms of pure logic these arguments are unassailable, and have rarely been challenged to any effect. In consequence they are often used to justify government interventions to correct or mitigate the effects of market failures. Such interventions may well be imperfect, but, provided the initial diagnosis of market failure is correct, it is hard to claim they are unnecessary. Market failures can result from inadequate competition, externalities such as pollution, taxes, trade barriers, financial barriers and distortions, poor policy, and many other causes.
The energy sector currently provides some particularly striking illustrations, most evidently in approaches to dealing with the damaging consequences (social and environmental costs) of greenhouse gas emissions (GHG). It is particularly easy to show, inter alia, that in the absence of rational pricing policies, especially in relation to greenhouse gas emissions, many of the conventional nostrums of energy policy, such as the importance of enforcing competition policy, can lead to more damaging outcomes when the bigger issue, adequate levels of carbon pricing, remains unaddressed.
There are many major market failures that impact the energy sector, but the simplest to describe and most prominent starting point is the “greatest market failure in human history”. This is the fact that social and environmental costs of CO2 emissions (an “externality” for economists) are either not priced at all into production and consumption choices, or, as with the EU’s emissions trading scheme (ETS), are only priced at a fraction of the true cost. [The current European carbon price is around €22 per tonne, and has been below €10 for most of the last decade. I have in other contexts quoted, purely as indicators, a UK Committee on Climate Change number of around €75, and of anywhere from €200 to €600 per tonne for carbon sequestration (“carbon trees”). Others, focusing on the potentially catastrophic consequences of out of control climate change, will suggest even higher numbers.] The real point is the massive scale of consequential economic distortion, reflecting both the size of the anomaly and the central and essential role of the energy sector.
At least for the energy sector, we certainly inhabit a world of the second best. Even apparently simple economic nostrums become highly suspect. Policies and measures that were assumed automatically to promote the greater good suddenly become questionable.
Competition policy can become dysfunctional. Ensuring more effective competition is supposed to benefit us all. If so, what should we make of anti-cartel measures to prevent European power generators from reaching an agreement to limit US coal imports? The effect of this is to substitute coal for gas, and substantially increase carbon emissions. The social and environmental cost of this will be an order of magnitude higher than the relatively small benefit to European consumers. (See also this link on this site.)
Serious distortion means improvements in productive efficiency can make things worse? More efficient production leads, in a competitive environment, to lower prices for consumers and encourages higher consumption. Usually this is a good thing, but if the consequences include higher emissions this may not be the case. Again, the “true” cost of additional environmental and social damage will outweigh the apparent benefit to consumers.
The Green Paradox. The absence of adequate carbon pricing now, combined with the uncertainties around future carbon taxes or restrictions, creates a positive incentive to accelerate fossil resource depletion and greatly increased emissions. (See recent comment on this site.)
Distortions to environmental policy. Even when there are policy interventions to compensate for the absence of an adequate carbon tax, these will be distorted by failure to reflect the high cost of emissions, and particularly current against future emissions, ie the time profile.(See a longer article on, and one referenced from, this site.)
Interaction with deficiencies in retail tariffs. Further issues are introduced when gas and electricity retail tariffs are not cost reflective in recovering the network costs of supplying consumers, but recovering too much fixed cost through a unit rate partially offsets the failure to price carbon correctly. Some of these issues are discussed in a recent paper for Energy Systems Catapult, but their resolution will get more attention, and we will return to this subject.
And what should we conclude from all this? The main observation perhaps is that the world is a complex place, does not conform to theoretical conditions, and has problems not amenable to simplistic economic theories or ideologies. The intricate reasoning and analysis around market imperfections are in one sense what policy, and energy policy in particular, is all about. This is a general theme to which we shall return time and again.
 An excellent summary of the divide, on this issue, between economists is provided by this link to a Rodrik blog: https://rodrik.typepad.com/dani_rodriks_weblog/2007/08/why-do-economis.html
Many articles and blogs by economists like Stiglitz and Krugman will also deal with examples of market failure in areas as diverse as trade policy and health care.
 Nicholas Stern
 These issues are very well described in this link, to a 2013 case involving Dutch competition authorities: Sustainable Competition law; Competition Law Kills Coal Closure ...
 . NORWAY’S DISINVESTMENT IN OIL, THE GREEN PARADOX, AND A WEAKNESS OF POLICY TOWARDS GLOBAL CLIMATE RISKS.
Fuller discussion on this topic can be found in the author’s earlier paper. Cumulative Carbon Emissions And Climate Change: Has The Economics Of Climate Policies Lost Contact With The Physics?, John Rhys, OIES Working Paper EV 57, July 2011.
 See the full report here: Cost Reflective Pricing in Energy Networks: The nature of future tariffs, and implications for households and their technology choices