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You Broke It, You Bought It, but Who Got Paid? Climate Economics 101 Continued

by James Barrett • August 4, 2010 @ 10:27 am

In my last post, I described the Fundamental Theorem of Climate Economics as “You break it, you buy it.” Most everyone has seen this policy in place somewhere or another, and most people accept it as more or less fair to both sides of the equation. In law, it’s called the doctrine of strict liability and it applies in many situations.

One of the aspects of the rule that is important to the climate conversation is that, from an economic standpoint, it doesn’t matter if, once you break something, you actually pay the owner for the damage. The You Break It You Buy It doctrine is important because, when it works, it gives people the incentive to behave appropriately. In the context of a gift shop with lots of fragile objects for sale, the objective is to get us to take enough care to avoid breaking the merchandise.

Obviously, if there was no penalty for breaking things, we may not take enough care (or keep a close enough eye on our kids). With a You Break It You Buy It policy in place, the shop owners set the penalty of an accident high enough so that we either do enough to avoid an accident or choose a level of care beyond which it’s the cost of being more careful is not worth the reduced accident risk. Perhaps it’s the difference between holding a toddler’s hand and carrying him around the store (which can be quite costly to your arms, back, ears, and patience).

In reality, the decision process is probably not as explicit as I describe it but rather instantaneous and somewhat instinctual. Nonetheless, we make some form of this calculation all the time. After all, the only way to absolutely guarantee that we don’t break something by accident is not to enter the shop in the first place. By entering, we’ve decided that the cost of absolute security is too high and that we’re willing to accept at least some risk.

The object of the policy is to get us to take the appropriate amount of care. If the expected cost of an accident is lower than the cost of taking care, than we’re not being careful enough: If I let my children run wild in a china shop, I’m obviously asking for trouble. On the other hand, if the cost of care is higher than the expected cost of an accident, then we’ve taken too much too much care: If I decide not to enter a store with nearly unbreakable merchandise because I’m afraid a child will break something, I’m being paranoid and over-cautious and taking too much care.

Notice that the shop owner doesn’t play much of a role. Once she sets the “you break it” policy, the decisions are entirely in our hands. In fact, beyond setting the policy, she plays no role at all.

Try the following thought experiment. Imagine you break something in the gift shop. You pay the owner whatever the price tag said, and leave the proud owner of a bag of broken glass. What if you handed the money to a stranger standing next to you, and he handed it to the shop owner? There’s no difference. You chose your level of risk and the amount of care you wanted to take and paid the consequences of the accident.

Now what if you handed the money to the stranger and walked away before you saw what he did with it? Maybe he handed it to the store owner, maybe he pocketed it and walked out.

There’s still no difference.

At a very fundamental level, it doesn’t matter. The objective of the You Break It You Buy It policy is to get you to take the right amount of care. It does that by imposing a penalty on you, and the cost you face is indifferent to what happens to the money once it leaves your wallet. Whatever happens to the money, the policy set up the right incentive structure. The stranger could burn the money you gave him, and you would still have faced the right incentive and the policy would work.

Of course, the store owner is not indifferent to what you do with the money, and that is the point. To be effective, a policy doesn’t have to be fair, it just has to set up the proper incentive structure.

What does this have to do with climate policy?

In a the gift shop setting, even if there was no you break it you buy it policy, most people are probably sympathetic enough to the shop owner to be careful not to break things. Most people don’t need the threat of punishment to force them to behave reasonably.

In climate policy, however, this turns out not to be the case (if it were, we wouldn’t be having this discussion). The victims of climate policy are not as easily identifiable and immediate as the shop owner. The costs of a few extra tons of pollution are likely to be small, and there is nothing like a price tag attached to tell us what they are. It’s only relatively recently that we’ve come to understand that there is any cost at all, and some people are still trying to claim that it’s zero.

So far, our only climate policy has been “you break it, no problem,” and the result has been the very serious and growing problem of a changing climate.

Effective climate policy seeks to fix this by putting a price on carbon emissions. For the policy to work, it has to induce the correct behavior from greenhouse gas emitters (i.e. to get them to reduce pollution to an appropriate level). From an economic standpoint, the problem is that the current price on carbon is zero. Setting the proper price is the first step in addressing the problem.

The field of Microeconomics is often called “Price Theory,” because, according to the theory, all we have to do is to make sure that all the prices are set appropriately, and free markets will produce the socially optimal outcome. When economists get involved with climate policy, the first thing we talk about is getting carbon prices right. Often, that’s also the only thing we talk about.

If we get the price right, is that enough?

Here’s a hint: Ask the shopkeeper.

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