Market pricing and externalities

The discussion on markets noted the importance attached to market prices for the purposes of resource allocation, and that mis-priced resources will result in sub-optimal usage. A key assumption here is that markets can and do price resources optimally.

In the short run, such a proposition may be difficult to defend. Market prices can fluctuate significantly, either under-pricing or over-pricing resources. However, over a longer period, market prices effectively reflect the combined best judgement of all market participants – this is what people are prepared to pay, based on their actual everyday actions.

The alternative to market pricing is for a central authority to set the price. The problem with central pricing is that such a price may be no nearer optimal than a market price. Further, the mechanism to change the price may be arbitrary or political, and the time between price changes may see supply and demand conditions shift considerably.

There are also risks with fixed pricing where the price is obviously out of balance with the market. During the 1984 election campaign, there was a flight of capital from New Zealand. Rather than devalue the fixed price New Zealand dollar to halt the flight, the Government chose to leave the exchange rate as it was. By the end of the election campaign, the Government had borrowed huge sums of money from overseas to prop up the dollar. The incoming Government had no choice but to devalue the dollar, providing a significant profit to those who speculated against the dollar as they repatriated their money. The New Zealand taxpayers not only underwrote the profits of the speculators, but were left with the debt from defending the currency. The decision to float the New Zealand dollar in 1985 was driven in no small part by the huge losses incurred in 1984, and the desire to remove that risk from the taxpayer.

Faced with the dilemma of which price setting mechanism to choose, economists often tend to favour the tyranny of the market over the tyranny of the central authority – because at least the market price will continually adjust to incorporate all known information.

So, market prices may not be perfect, but over the long term, they have a good chance at being better than the alternative!

However, there are situations where markets are known to be deficient in price-setting. One of these is in the area of externalities.

An externality occurs when there are side effects from a production process that has not been included in the pricing of its resources. Further, the effect of the externality is on a third party – i.e. someone other than the creator of the externality. Externalities are usually discussed in an adverse sense, but they can also be beneficial. Typical examples of externalities are water and air pollution, or Greenhouse Gas emissions.

Take the example of the burning of wood and coal in domestic fires for home heating around Christchurch. Several times each winter, calm conditions and temperature inversions lead to the smoke and particulate matter being trapped in the atmosphere around the city. This air pollution has several side effects – the air is unhealthy to breathe, it is visually unappealing, and it deposits particulate matter over exposed surfaces.

In this case, the burning of wood and coal by only some of the residents of Christchurch impacts on all residents of Christchurch, as well as visitors to the city. These impacts include increased health costs, extra time involved in cleaning, and dissatisfaction with the poor visibility created by the smoke.

The purchase price of the coal and wood does not include a cost for cleaning up the atmosphere, and even if a tax or levy were imposed on the purchase of these fuels, it could not be distributed to all the people affected.

The general principle for dealing with externalities is to internalise the cost as much as possible. In other words, the cost of dealing with the externality should be placed on those who create the externality.

In the case of water and air pollution, this may mean requiring polluters to make the air or water clean before it is released. Therefore, industrial users would require scrubbers to remove smoke particles and dairy farms would require oxidation ponds for the effluent from dairy sheds. Christchurch City Council is taking this type of approach to deal with its air quality issues with a ban on open fires, and a requirement to replace low efficiency wood and coal fires with higher efficiency models over a phase-in period. While this does not totally eliminate the problem, it does reduce the size of the externality, while the cost of upgrading the wood and coal fires falls on users of those heaters.