The Supply Chain Knowledge Problem

While current supply chain problems are unpleasant, they really should not be a surprise to anyone that understands the fundamental problem of economics, the knowledge problem. The knowledge problem, originally characterized by Hayek:

"The economic problem of society is not merely a problem of how to allocate given resources....it is a problem of utilization of knowledge which is not given to anyone in its totality."

This can be understood by recognizing that 'know how' and 'know what' are spread across many minds to paraphrase some of the work by economist Kenneth E. Boulding and as discussed in Peter Boettke's Living Economics. The knowledge problem is also exemplified in the words of Leonard E. Read's pencil in his essay I, Pencil, "Not a single person on the face of this earth knows how to make me."

How does this apply to our supply chain issues? Well because 'know how' and 'know what' are spread across so many minds, not a single person on the face of the earth knows how to make anything. As a result, no one has the knowledge to fix our supply chains. Our supply chains are the result of human action but not human design. They are the product of a hidden emergent order. Of course this is a feature and not a bug. As a result most consumers and policy makers usually remain comfortably blind to the knowledge problem and only briefly opened their eyes to notice when the meat counter was empty during the early days of COVID. Many refuse to see on the grounds of political or philosophical reasons, and employ rhetoric and support policy that bites the invisible hand that literally feeds them.

If planners and policy makers have viewed our economy as an engine that would automatically restart after shutting down like the engine of a car at a traffic light, they have committed the folly of every social planner in history. Instead of thinking of our economy and the supply chains that sustain it as a mechanical system that can be engineered by technicians, a better analogy is an evolving ecosystem. Each product we consume and its components have evolved to fit into very specific niches. We must think of our supply chains as habitats that have been threatened by COVID and our response to it.

Just as restoring an ecosystem after an environmental disaster requires an understanding of ecology, we must understand the ecology of our markets and supply chains in order to restore our economy and avoid an even worse ecological disaster. We must recognize that the knowledge problem post COVID is more challenging than pre covid made evident by recent price spikes and shortages that some people are calling inflation. We have to understand that our supply chains evolved over a number of years, even decades, and ‘regrowth’ will take time and things may not grow back to look like they did before.This could mean higher prices now and well into the near future for a number of goods, with some items reaching new higher equilibrium levels as tastes, preferences, and production practices may have changed post COVID. 

But this is not a monetary phenomenon. The stance of monetary policy cannot necessarily be determined simply by the level of interest rates but is a function of money supply relative to demand. Increasing the cost of credit in response to price changes that have non monetary but very micro foundational causes related mostly to supply chain disruptions could be a recipe for disaster. In the same way, we won’t print our way out of the supply chain crisis we are seeing. 

We should also be very careful on the fiscal policy front. Lawmakers are debating a 4 trillionish dollar spending package. We need to go through this with a fine tooth comb to understand how any changes might exacerbate demand given the current supply constraints and ensure that we don’t add additional frictions that would prevent workers from taking a job or businesses from expanding output. It goes without saying that should be very cautious about any hint of price controls during this period of transition.

Additionally we should consider all other supply side frictions including taxes and regulations. We learned during the pandemic the potential of relaxing prohibitions such as those in healthcare which allowed supply to creatively meet demand using telemedicine. What other opportunities exist to help rebuild our supply chains?

Policy makers must think carefully about how to respond going forward. We don't want to add fuel to the fire with misguided monetary, fiscal, and energy policy responses and must be willing to allow new species to emerge as different sustainable patterns of specialization and trade evolve post COIVD. If anything, COVID has reminded us all of the words of Frederick Hayek:"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

Notes and References:

Friedrich Hayek (September 1945). "The Use of Knowledge in Society" (PDF). The American Economic Review. 35 (4): 519–530

Living EconomicsYesterday, Today, and Tomorrow. Peter J. Boettke. 2012.

The Knowledge Problem and Innovation Within Firms

In his podcast Vance Crowe has a discussion with Rick Holton about venture capital and why firms can't innovate. Vance uses a great analogy about the nature of firms and innovation: 

"you think of these large capitalist companies....but once you are inside the walls of a company there's a form of communism that goes on"

This remark is very similar to what Ronald Coase (who won the Nobel prize in economics in part because of his insights about the existence of large firms) said about firms in his famous article The Nature of the Firm. He effectively described firms as little islands of socialism:

"we find “islands of conscious power in this ocean of unconscious co‐operation like lumps of butter coagulating in a pail of buttermilk...Why are there these “islands of conscious power”? 

Indeed why? And how?!  Doesn't this conflict with Hayek? If the very idea of socialism is impossible due to the knowledge problem, then how can firms get away with it? Coase explains:

Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur‐co‐ordinator, who directs production....the distinguishing mark of the firm is the supersession of the price mechanism.…“related to an outside network of relative prices and costs."

Innovation happens largely as part of the entrepreneur's (including venture capital) response to the uncertainty that firms face and their inability to 'calculate.' The role of the entrepreneur and profit and loss system (capitalism) is to maintain alignment with the 'outside network of relative prices and costs' or else firms could not exist, and we would have no innovation. 

It's the profit system that allows firms to thrive despite their internal struggle with the knowledge problem. The market, venture capital, and the entrepreneurial response to uncertainty represents a set of institutions for managing innovations that are not possible within the planned economies of individual firms. 

References:

The Vance Crowe Podcast. Rick Holton: Venture Capitalist on failed deals why corps can't innovate & helping the imprisoned. March 15, 2021. https://share.transistor.fm/s/0b9824be  (14:50)

Coase, R.H. (1937), The Nature of the Firm. Economica, 4: 386-405. https://doi.org/10.1111/j.1468-0335.1937.tb00002.

The Use of Knowledge in Society. F.A. Hayek. The American Economic Review Vol 35 No 4 (Sept 1945) p. 519-530

See also: The Knowledge Problem in Firms

Vaccines and the Knowledge Problem

 Below is an excerpt from the blog Marginal Revolution:

"Northam’s health department has also forbidden people from crossing county lines to get the vaccine. If the county next to you has an abundance of the vaccine, you can’t get it. Only residents of that county may get their vaccine.These new rules will result in many people either having their vaccination appointment canceled or delayed for months." 

https://marginalrevolution.com/marginalrevolution/2021/01/our-virginia-regulatory-state-is-failing-us.html 

Vaccination clearly represents a public good and arguably falls within one of the legitimate roles of government. That means socially planned vaccine distribution. Chic-fil-A knows how to distribute chicken sandwiches efficiently through their drive through during a once in a hundred year pandemic, but government bureaucrats do not (and fundamentally can not! ) know how to distribute vaccines during a once in a hundred year pandemic.

Socially planned vaccination will demonstrate all of the key characteristics of social planning and socially planned economies: delays, shortages, excess, waste, abuse, arbitrary rules etc. This is NOT a partisan anti-government rant, or even a subjective personal point of view. It is an objective quality of bureaucratic decision making that no economist can deny. It's as much the nature of social planning as it is the nature of dogs to bark.

Socialism Can't Calculate

At the root of these unfortunate consequences is what economist Frederick Hayek characterized as the knowledge problem. Governments allocate resources in a fundamentally different way than individuals do in through the price system. The result is a well coordinated spontaneous order guided by prices that reflect tradeoffs based on the knowledge and preferences of millions of individual decision makers. Governments (via democratic processes and social planning) allocate resources based on the limited knowledge and preferences of a few voters, elected officials, or appointed bureaucrats. The fundamental problem facing all forms of government including democracies is that centralized decision makers never have enough information or proper incentives to act on the information at hand. That's the knowledge problem. Its not just a problem for governments, its also one of the biggest challenges faced by firms too.

Socially planned economies could never achieve the level of knowledge coordination required to give us things we take for granted today like smart phones:

   

 Or even something as simple and basic as pencils:

   

So What is the Answer? Federalism.

The fact remains that vaccination is still a public good and falls squarely and solidly within the scope of government decision making. Operation Warp Speed is a great example of how the national government can achieve some success in this space. By incentivizing production and largely getting out of the way from a regulatory perspective the national government was actually able to facilitate ways for private firms to step in and solve the knowledge problem related to vaccine discovery and production. These kinds of public private partnerships are a model for at least reducing the information loss associated with social planning writ large.

So we are forced into a socially planned vaccination effort. The good news, in the United States at least, instead of putting everything at risk with a single national plan, we get 50 chances to get it right, one in each state. While no one state will be able to necessarily avoid the knowledge problem, some may do better than others and we can learn from successes and failures getting closer to an approximation of the feedback mechanisms provided by the price system. This is one of the strongest arguments for our constitutional republic and federalism that our founders envisioned. 

By flirting with the nirvana fallacy and we might claim that a single national plan would be better than 50 different inconsistent plans - especially if some states prove incompetent. While we might argue that one set of planners (or administration) at the national level could get better results than another (enter political partisanship) that doesn't change the fundamental nature of the knowledge problem. Maybe there are economies of scale that the national government can realize, or maybe it has access to better resources or leadership with more expertise. Would these gains make up for what is lost in the local knowledge that states and counties have that the federal government could never grasp? Devolve as much decision making as possible to the most local level possible. Cooperation between national government, private enterprise, and local initiatives is probably the better answer. In fact, the current approach of the federal government incentivizing the development and purchasing a large supply of vaccines while allowing the states to distribute according to their own plans is consistent with this federalist approach.

Diversification is our best hedge against the the many risks of socially planned decision making. And it's probably the greatest reason our system of government has been able to tolerate a mixed economy as well as it has the last 50 years or so. 

Milton Friedman said: 

"the ballot box produces conformity without unanimity, the marketplace produces unanimity without conformity."

Our experience with a socially planned vaccination effort should provide teachable moments we can point back to in the future when politicians propose planning other aspects of our economy that aren't necessarily national emergencies or public goods. We don't want to introduce unnecessary fragility into our lives by creating unnecessary dependencies on plans whose relative failure or success has to rely on who's in charge. 

Note: In no way should any point above be used as an argument to undermine the effort to vaccinate the public at large.  This is not intended to be a criticism of the current vaccine effort or government. In fact the current approach is largely consistent with the ideals of federalism discussed above. This essay is meant to be totally descriptive and comparative. Getting to 70% + herd immunity is vital to fighting the pandemic. It's a huge public good and every effort by state, federal, and local government agencies and private institutions and individuals deserve great applause. We cannot expect to hold the performance of socially planned efforts against the standards of the price system in terms of their relative ability to solve the knowledge problem. The above is not an attempt to do so, but to illustrate the fundamental differences in resource allocation under a system of social planning compared to the price system. The distribution of vaccines provides a palpable illustration. Neither should this in any way imply that government employees and bureaucrats are incompetent. Everyone responds to incentives. The issue is incentive alignment.

Reference:

The Use of Knowledge in Society. F.A. Hayek. The American Economic Review Vol 35 No 4 (Sept 1945) p. 519-530

More about markets and the knowledge problem:

Models and Assumptions: Efficient Markets, Imperfect Information, Rationality, and Prices 

Economics, Evidence, and High Causal Density

 

 Related:

The use of knowledge in disaster relief: http://www.independent.org/publications/tir/article.asp?a=628

The Government's Response to Hurricane Katrina- A Public Choice Analysis: http://www.peterleeson.com/hurricane_katrina.pdf

The Knowledge Problem in Firms

Micromanagement and many of the coordination and alignment problems within firms are actually manifestations of what Hayek characterized as the knowledge problem and was his major and most damning criticism of socialism. It's a limitation of planning and bureaucracy in general and applies to both profit and non-profit organizations. You could characterize Hayek's concept of firms as being 'little islands of socialism in a sea of markets.' The only saving grace for firms is that because bureaucracy and management don't scale so well in the long run the limits of irrationally are eventually tested by the external pressures of the price system which in a capitalist economy results in profit and loss, reorganizations, mergers, or bankruptcies. Creative destruction. Non-profits and government institutions have to rely on other kinds of institutional arrangements to work through these frictions. Better leadership and institutional arrangements can make things better but will ever only go so far solving the knowledge problem. 

Economics, Evidence, and High Causal Density

How do we form our beliefs about the solutions to societies most complex problems? Do we trust data? Theory? Both? What does it mean to base policy on science and evidence?

According to Manski:

"Social scientists and policymakers alike seem driven to draw sharp conclusions, even when these can be generated only by imposing much stronger assumptions than can be defended. We need to develop a greater tolerance for ambiguity. We must face up to the fact that we cannot answer all of the questions that we ask."

I think Russ Roberts puts it well in his EconTalk Episode with Noah Smith:

"Can you think of a study that was so decisively performed in terms of the crossing of t's and dotting of i's that the identification and all the econometric challenges were met with such impressiveness that people on the other side of the debate had to throw up their hands and say, 'Well, I guess I was wrong. I've got to change my view.' Because I can't think of one. I can't think of one. And if that's true, then I would suggest that economics has some serious problems in claiming it's a science."

When it comes to evidence there are lots of challenges. For the most part, in economics and the social sciences it's often impossible to implement randomized controlled trials to identify treatment effects related to policy changes. For the most part we have to leverage observational data using quasi-experimental designs. The challenge for both approaches as Jim Manzi discusses in his book ''Uncontrolled: The Surprising Payoff of Trial-and-Error for Business, Politics, and Society'  is the issue of 'high causal density.'

In an environment of high causal density "the number of causes of variation in outcomes is enormous, and each has significant potential effects compared with those of the potential cause of interest. We don't know enough to list each of them and hold them constant, but if we randomly assign patients to the test and control groups, then these hidden conditionals won't confound our estimate of treatment causality."

Unfortunately in the social sciences, causal pathways are extremely complex. There are always hidden conditionals we may not be able to measure or don't have sufficient knowledge to even consider. Given that hidden conditionals are always present, a well entrenched proponent of a given policy can always find a reason to explain why it has failed to prove itself out in the face of evidence.

But Jim does more than offer criticisms of theory and methods. He introduces the concept of 'Liberty as Means.'  Embracing the concepts of evolutionary economics, he promotes a flexible system of government that sounds a lot like federalism. As he discusses, the mistake we often see from both the right and the left is enforcement of social norms at the national level vs. fostering numerous experiments at the local level.

While economic theory and applied econometrics are useful and powerful tools for policy analysis,  these tools will not necessarily help provide clear cut  always defensible evidence to improve public policy. These methods will never discover a 'Polio vaccine' for policy. It is in fact their shortcomings that provide the strongest argument for our constitutional republic and federalism that our founders envisioned.

Reference: Uncontrolled: The Surprising Payoff of Trial-and-Error for Business, Politics, and Society, by Jim Manzi https://www.amazon.com/Uncontrolled-Surprising-Trial---Error-Business/dp/046502324X/ 

See also: EconTalk: Manzi on Knowledge, Policy, and Uncontrolled

*this is cross posted at: https://ageconomist.blogspot.com/2019/01/economics-evidence-and-high-causal.html?m=0 

Price Gouging and the Knowledge Problem

 If we should make price gouging illegal, then we have to ask, how do we solve the 'knowledge' problem? i.e.

Is there a 'more appropriate' price that should be charged? How do we find a price that ensures that the intensity of your desire/need for a generator is consistent with my willingness to provide one? Should we rely on market forces and prices at all or simply have some authority distribute generators based on some set of rules? Rules based on what criteria? How many generators are required and how do we make sure that they get to the people that have the greatest need/desire for them? i.e. how do we know if generators are allocated to the most highly valued use? What lessons can we learn from Hurricane Katrina about the government's ability to mobilize resources during a natural disaster? See also:

The use of knowledge in disaster relief: http://www.independent.org/publications/tir/article.asp?a=628

The Government's Response to Hurricane Katrina- A Public Choice Analysis: http://www.peterleeson.com/hurricane_katrina.pdf
The Problem with Price Gouging Laws-Regulation Spring 2011: http://www.cato.org/pubs/regulation/regv34n1/regv34n1-1.pdf

The Knowledge Problem - blog posts related to price gouging: http://knowledgeproblem.com/tag/price-gouging/ 

Environmental Economics blog post related to price gouging: http://www.env-econ.net/2009/06/mike-giberson-on-antiprice-gouging-laws.html 

Models and Assumptions: Efficient Markets, Imperfect Information, Rationality, and Prices

“The relevant question to ask about the “assumptions” of a theory is not whether they are descriptively “realistic,” for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.” – Milton Friedman, Essays in Positive Economics 

"The great free market economic thinkers from Adam Smith to F. A. Hayek never argued that individuals were hyper-rational actors possessed with full and complete information, operating in perfectly competitive markets.... Efficient markets are an outcome of a process of discovery, learning, and adjustment, not an assumption going into the analysis." - http://theeuropean-magazine.com/348-boettke-peter/349-the-legacy-of-smith-and-hayek

 “the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coördinate the separate actions of different people in the same way as subjective values help the individual to coördinate the parts of his plan. Of course, these adjustments are probably never "perfect" in the sense in which the economist conceives of them in his equilibrium analysis. But I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency. To assume all the knowledge to be given to a single mind in the same manner in which we assume it to be given to us as the explaining economists is to assume the problem away and to disregard everything that is important and significant in the real world” – Hayek, The Use of Knowledge in Society

"I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge" - F.A. Hayek, The Pretense of Knowledge

 “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” - Frederick Hayek, The Fatal Conceit

“Neither all ends pursued, nor all means used, are known or need to be known to anybody, in order for them to be taken account of within a spontaneous order.” - Hayek, The Fatal Conceit

 "The financial crisis invalidated a naïve notion of "efficient markets," but the most sophisticated version is still viable. Whereas the invalidated version holds that markets never err and always adjust instantaneously, the sophisticated version, associated with the ideas of Adam Smith and F. A. Hayek, holds that markets mobilize individuals to realize gains from trade and to innovate and thereby produce generalized prosperity." http://www.independent.org/publications/tir/article.asp?a=762

Robert Murphy points out in his textbook 'Lessons for the Young Economist': "When we look at the world and try to make some sense of it, one of the most basic and crucial distinctions we all make—usually without even realizing it—is the difference between purposeful action versus mindless behavior...The lessons in this book apply to purposeful actions performed by conscious people who have goals in mind… The economic principles in this book are not confined to “perfectly rational people.” The lessons in these pages apply to real people who use their minds to make exchanges in the real world every day."

 Economics deals with the real actions of real men. Its [laws] refer neither to ideal nor to perfect men, neither to the phantom of a fabulous economic man (homo oeconomicus) nor to the statistical notion of an average man. . . . Man with all his weaknesses and limitations, every man as he lives and acts, is the subject matter of [economics]. —Ludwig von Mises, Human Action (Auburn, Ala.: Ludwig von Mises Institute, 1998), pp. 646–47

I, Pencil and I, Smartphone

Spontaneous Order

Models in Economics: Game Theory

From the movie, A Beautiful Mind.
Full Screen - click here

Homeland Security, The Knowledge Problem & Constitution Week

Below are excerpts from two economists (David Henderson and Sam Clovis) on faculty at the Naval Post Graduate School. Note, Henderson will be speakingat WKU this year during Constitution Week

September 12, 2011
8:00 pm - 9:30 pm

Grise Hall 235

 (special thanks to the BB&T Center For the Study of Capitalism at WKU).

"Central economic planning can't work, explained Hayek, because no small number of people at the top, however brilliant or informed, can aggregate all the trillions of pieces of data needed to plan an economy well. The main information that matters in real time is what Hayek called "knowledge of particular circumstances of time and place" and this information is necessarily decentralized: it exists only fleetingly in the minds of millions of people.....Hayek's argument applies whether the good being produced is food, steel, or internal security. In fact, in her testimony before the 9/11Commission, Dr. Rice explained the problems with centralization eloquently;

                  You have thousands of pieces of information . . . and you have to depend to a certain degree on the intelligence agencies to tell you what is actually relevant,

                 what is actually based on sound sources, what is speculative.

The lesson of September 11 is not that government should plan better and not that a Republican president plans better or worse than a Democrat president. The lesson of 9/11 is that central planning doesn't work and that government should not get in the way of our planning. "  LINK

In addition to the  'knowledge problem' discussed above, Sobel and Leeson have identified several other issues with the top down approaches in homeland security regarding incentives, the tragedy of the anticommons, and type II error policy bias. Absent market prices, how do we deal with these issues? Attempts to address these problems, to some extent, can be found in scholarship related to homeland security and federalism:

"an agency that forms partnerships with state and local governments instead of coercive top-down regulation-heavy regimes is an appropriate response on the part of the national government to deal with the particular needs of all the other governments in this country. Further, this agency should work at giving state and local governments as much flexibility as possible in dealing with own-source challenges. By facilitating cooperative networks of communities/jurisdictions a far more realistic and pragmatic approach to all hazards preparedness is a logical outcome. The national government should provide the organization around which such networking might take place." –Homeland Security Affairs VI, no. 2 (May 2010) – Sam Clovis

Efficient Markets and Prices

‎"I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge" - F.A. Hayek

"The financial crisis invalidated a naïve notion of "efficient markets," but the most sophisticated version is still viable. Whereas the invalidated version holds that markets never err and always adjust instantaneously, the sophisticated version, associated with the ideas of Adam Smith and F. A. Hayek, holds that markets mobilize individuals to realize gains from trade and to innovate and thereby produce generalized prosperity."

"In the 1940s, Hayek warned his fellow economists of the misleading standards of perfect competition and static efficiency in assessing the market economy. As he wrote in Individualism and Economic Order, "[T]hese adjustments are probably never 'perfect' in the sense which the economist conceives them in his equilibrium analysis. But I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency" (1948, 87)"

http://www.independent.org/publications/tir/article.asp?a=762

"The great free market economic thinkers from Adam Smith to F. A. Hayek never argued that individuals were hyper-rational actors possessed with full and complete information, operating in perfectly competitive markets.... Efficient markets are an outcome of a process of discovery, learning, and adjustment, not an assumption going into the analysis."

http://theeuropean-magazine.com/348-boettke-peter/349-the-legacy-of-smith-and-hayek 

Pricing Carbon

"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." - Frederick Hayek

A basic application of climate economics:

What economists must do is take consensus science into account, and approximate what the price of carbon should be to limit economic damages from CO2. This level will be achieved where the marginal cost of reducing carbon emissions is equal to the benefits of decreased damages from climate change in the future.  

Nordhaus ( Using the DICE-2007 model, and based on the science of the IPCC Fourth Assessment Report) prices carbon at about $30/ ton, with the average person in the US generating about 5tons/yr, for a total of about $150/year, or .09 /gallon of gas and .01/kwh for electricity. However, the Stern Proposal(proposed by another economist in the U.K) estimates the damage from global warming to be closer to $300/ton carbon for the next two decades. In this case we are looking at increasing gas prices by about $1.20/gallon. (read more)

Discussion:

How can economics narrow the gap between these approaches? Should we question the idea of 'pricing carbon' or the assumption that the impacts of climate change (manmade or not) fail to be captured in market interactions? 

Carbon taxes and the climate change knowledge problem
 
The idea of pricing carbon is that given the assumption that CO2 production has a negative impact on climate change and so many goods and services are carbon intensive, if we can put a price on carbon (paid by corporations that trade carbon permits or a carbon tax)  to capture the value of the negative externality, this will 'trickle down' to the mirco level, such that when you buy an ice cream cone, gasoline, or a pencil, the impact of your choice on the climate will be captured in the price you pay for it.  This is the climate change knowledge problem. We have to get the initial price of CO2 correct so that the 'trickle down' economics works at the micro level and we ward off catastrophic climate change.

The correct price for carbon will balance the marginal cost of reducing carbon emissions with benefits of decreased damages from climate change in the future.  As Armstrong points out, there are few scientific forecasts related to these future damages. And technological change allows us to continually respond the volatile effects of climate change. Advances in biotechnology are allowing us to produce more climate resilient crops, all the while reducing our carbon footprint in agriculture.  How can we incorporate this knowledge into our calculus? When it comes to the costs of reducing carbon emissions, it isn't any easier. What are the opportunity costs of resources invested in emissions mitigation (voluntarily vs. those mandated or incentivised by government administered prices for carbon)?   

Tradeable Permits

Some will argue that instead of a tax, you can get similar or superior results by defining property rights in the form of carbon credits or tradeable permits. Then markets can solve the information problem via the price mechanism that manifests in the trading of permits. The problem still stands. Someone has to initially assign some quantity of permits to 'polluters.' This quantity has to be based on some determination of an 'optimal' quantity of CO2 emissions. This also requires the information necessary for determining the marginal benefits and costs of each associated unit if CO2.  The knowledge problem has not been solved, just reformulated in a way that is equivalently intractable for planners to solve. Unless planners get this quantity right, the price that 'trickles down' at the micro level for all goods and services will be too high or too low, based on the artificial scarcity or excess created by the planners' miscalculation. The classic exampleof the Coase Theorem solves the externality of pollution of common property like a lake by clearly assigning property rights. The optimal level or quantity of pollution is a separate problem solved by the price mechanism via subsequent exchanges of property rights or contracting. In the case of CO2, the assignment of property rights and the optimal quantity of pollution both have to simultaneously be determined. You have to determine some initial quantity of pollution in order to create the permits (which a are then traded to establish a price).

From the Capitalism Today Blog at Western Kentucky University there was recently adiscussion regarding macroeconomic equilibrium and the difficulties of knowing the micro-level equilibrium for something (seemingly) as simple as ice cream:

"They act as if not only there is equilibrium, but that they know where it is.  If anyone knows exactly how many ice cream cones the US needs to produce tomorrow, please raise your hands.  What no hands?  No one can know the "appropriate" amount of ice cream cone production for today let alone for tomorrow.  The $15 trillion US economy makes a lot more than just ice cream cones."

I think this analogy may also apply to pricing carbon. Ice cream comes in lots of varieties and flavors, produced and marketed various ways (natural, conventional, biotech, hormone free, organic, home made, store bought, ice cream trucks, retail outlets). Ice cream is pretty differentiated when you think about it. What about carbon?Noone knows how to set a 'national' or even a 'local' price for pencils, or the correct quantity of pencils that our complex world requires.  Why do we expect carbon to be any different than ice cream or pencils? Even if economists like Nordhous and Stern were in agreement, their solutions would not sufficiently deal with climate change's knowledge problem. 

Some will agree that planners are no match for markets in determining prices and quantities, but because we currently have no established property rights to the atmosphere there is no 'price' for carbon. As such, there are going to be consequences if we do nothing, and the next best solution is an attempt, even if not perfect, to price carbon because it is not considered in market transactions. 

Is that really the next best solution and is it true that the price mechanism totally ignores CO2? 
  
What is carbon really? 'Carbon' in an economy manifests itself in how we heat and cool our homes, how we manufacture goods and services, how we respond to emergencies, how we travel and transport goods, how we store and retrieve information. Leonard E. Read's essay I, Pencil demonstrates  the complexity involved in an economy that thrives on disaggregated information and processes with numerous feedback loops and interactions.  In a complex society, carbon is no different, and while it may not be explicitly and directly priced, it is hard to believe that its role is not part of the pool of knowledge characterized by the partial bits of information held by all individuals in society. 

In fact, while politicians and special interests argue over the politically optimal arrangement of regulatory protections and subsidies to 'combat climate change' markets have responded in much more meaningful ways without any bureaucratically administered price of carbon or cap on CO2.

As Dr. Don Boudreaux of George Mason University points out in a recent piece in the Wall Street Journal, in response to climate alarmists' connecting violent storms and climate change (and obviously calling for centralized solutons to combat it): (read more)

 "...because of modern industrial and technological advances—radar, stronger yet lighter building materials, more reliable electronic warning devices, and longer-lasting packaged foods—we are better protected from nature's fury today than at any other time in human history."

Perhaps the innovations in green technologies in agriculture provide the greatest example of mitigating climate change:

Total decreases in carbon dioxide as a result of using biotech crops was equivalent to removing 6 million cars from the road in 2007. The carbon footprint for a gallon of milk produced in 2007 was only 37 percent of that produced in 1944. For every 1 million cows, the reduction in global warming potential from rBST supplemented cows is equivalent to removing 400K cars from the roadways or planting 300 million trees. The use of grain and pharmaceutical technology in beef production has resulted in a nearly 40 percent reduction in greenhouse gases (GHGs) per pound of beef compared to grass feeding. Intensive agriculture has actually has a mitigating effect on climate change with a reduction of 68 kgC (249 kgCO2e) emissions relative to 1961 technology. (read more)

Conclusion: 

We are not really sure how to price carbon, and what we observe in all of these instances is that despite the absence of a centrally planned price or quantity of carbon, people are making choices that optimize its use or production. Because we don't have the knowledge to price carbon, we don't know that the resources expended in 1) lobbying lawmakers to tweak the proposed rules and regulations 2) mitigating the costs of a centrally planned price or quantity, would not have higher valued uses mitigating climate change in other ways (like investment in green technologies like biotech). The best approach for dealing with climate change or any environmental problem is to develop resilient market based economies that are able to invest in the technology necessary to adapt to ever changing resource constraints.

Knowledge Problem

Governments allocate resources in a fundamentally different way than individuals behaving cooperatively in voluntary exchange through the plan coordinating and knowledge generating mechanisms of markets. Individuals acting in their own interest results in a spontanous order guided by prices which reflect tradeoffs based on the knowledge and preferences of millions of individuals. Governments (via democratic processes) allocate resources based on the limited knowledge and preferences of a few voters, elected officials, or appointed bureaucrats. The fundamental problem facing all forms of government including democracies is that centralized decision makers never have enough information or proper incentives to act on the information at hand. As Economist F.A. Hayek (1945) said:

'the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all separate individuals possess'

This is referred to by economists as the 'knowledge problem.'

For more information related to issues regarding democratic decision making, see Public Choice Analysis.  

SOURCES:
The Use of Knowledge in Society
F.A. Hayek
The American Economic Review Vol 35 No 4 (Sept 1945) p. 519-530

Markets and Knowledge- with Applications to Disaster Relief

I Pencil -The actual essay starts on page 4 within the document (actually page 8 in the pdf) This discusses the role that prices play in conveying knowledge and directing and organizing behavior in society- often described as a ‘spontaneous order.’


Economics has many applications outside of what you may stereotypically have in mind. Besides giving insight into how to run a business, economic principles apply to other areas of human behavior, like for instance, disaster response:

The Use of Knowledge in Disaster Relief Management


Government’s Response to Hurricane Katrina: A public choice analysis


Again, these are really upper level applications of basic principles of economics. Don’t feel overwhelmed by the material. Just scan through and try to get a general idea. What we will cover in class will be much more basic. However, these are great examples of applications of the principles we will talk about in class.