Let the Market Work
Although it’s not my area of expertise, Environmental Economics has become one of my favourite economics blogs. Recently they had some discussion about water pricing. The question is how to ration water use in a drought. There are basically two ways to do it: (1) Let the market work and let the price rise to choke off some demand so the reduced supply is adequate, or (2) Keep prices fixed but impose some other arbitrary restrictions on use like banning car washing or using hoses on certain days of the week, etc.
As the Environmental Economics guys explain, letting the price rise is the better solution. Aside from the fact that people find ways to get around usage restrictions, letting the price rise means that those who use the water are those who value it the most. Basically, willingness to pay for something reflects its value to that person, and water like all scarce resources should end up in the hands of whoever values it the most, in order to make the best use of it.
One argument against this is that it might be inequitable. During a water shortage, if the water price rises, why should a rich person be able to water his rose garden because he can afford to, while his poor neighbour can’t afford to wash his clothes? This is a valid criticism — market outcomes are efficient in that they allocate scarce resources to whoever values them the most, but they’re not guaranteed to be “fair” according to whatever definition of fairness you want to use. If you care about equity, then during a water shortage you might think it’s a good idea to leave prices alone and ban rose watering, so the rich guy has to cut back, while the poor family can still afford clean clothes.
That’s a reasonable argument, but it turns out that you can achieve an even better outcome during a water shortage by recognising that the reason the poor family can’t afford to wash their clothes if the water price goes up is because they’re poor, not because of the water shortage per se. So your real complaint is not that a high price of water is “unfair”, but rather that it’s unfair that some people are rich and some are poor.
So instead of keeping the water price constant and imposing restrictions on use, suppose you let the price go up, but tax the rich guy and transfer that money to the poor family. Then the poor family is no longer poor, and the market for water can still do its job of making sure that scarce water goes to those who value it the most. Furthermore, the poor family can spend the extra money that you give them on whatever they want, which may not necessarily be water. Suppose you gave them just enough extra money that they could afford their original water consumption at the pre-shortage prices. They can always choose to consume that amount of water if they want, and be just as well of as before. But if they value something else more highly, they can spend part of the money that you give them on whatever that is, and they’ll be better off.
In summary, the “unfairness” caused by a high water price during a shortage hurting poor people isn’t caused by the water shortage itself, but by the fact that these people are poor. You can improve the welfare of these people during a shortage by keeping prices low but imposing restrictions on other people’s use. But you can do even better by solving the poverty problem directly through transferring wealth between people according to your ideal of “fairness” while using the power of the market to allocate scarce resources efficiently.
This is a tricky concept to explain, and I’m not sure if I’ve done a very good job. I think a specific example would be useful to illustrate it, so I’ll try to think of one.
3 Comments
I read with interest your argument for letting markets put resources to their highest value. It all made sense until I reached the taxing the rich part. Why is taxing the rich and distributing that to the poor “fair?” Isn’t money a resource as well? May be the marginal value of the last unit of money to the rich person is higher than it is to the poor person. Also, from a non-economics stand point it’s not just by chance that a person is rich (at least not all the time). How fair is it to take away his hard earned income and give it to someone else?
Koyel: Defining “fair” is a difficult task as you said. While money is not a resource by itself (it can’t be used to produce things directly like real resources can), if you want to redistribute wealth as I said then it will make rich people worse off, as you correctly pointed out. However, most societies seem to prefer not to have economic outcomes that are extremely skewed in the sense that there is a huge difference between rich and poor. So, without passing judgement on whether this is the right thing to do or not, economic policies are often used to transfer wealth.
Your comment also made me realise that my story wasn’t quite complete. In the water shortage example, the reason for not letting prices adjust and imposing restrictions on use instead is presumably because of some ‘fairness’ argument as I tried to explain — letting the price adjust might hurt poor people much more than it hurts rich people. So the use restrictions are designed to try to prevent that. As I said, an alternative way to achieve a similar outcome is to let prices adjust, but compensate people for being poor. Both of these policies have a cost to someone. Holding prices constant and restricting use prevents the market from working efficiently and allocating scarce water to whoever values it most. Transferring wealth from rich to poor imposes costs on the rich.
The point I was trying to make was that the policy of letting prices adjust and using transfers to achieve ‘fairness’ is a less costly way (overall) of achieving that ‘fairness’, compared to the other policy of keeping prices constant and restricting use. The difficult thing is to explain exactly why this is without resorting to mathematics. I’ll keep thinking about it.
Thanks. I understand why it is a more efficient (less costly) solution. Economic policies in most countries do not follow a progressive tax structure. Often times middle and high income groups are lumped in the same category. Every time there’s an increase in tax rates to transfer wealth, the middle income groups get hurt the most. It also acts as a disincentive to work. Although it achieves the desired economic outcome, it leads to a change in social structure. But that’s a different issues I guess. Your point, however, is well taken. Thanks again for the explanation.