Economics vs. What We're Doing Today

They're not the same thing.

In class today, we explored advances in negotiation theory, focusing in particular on environmental negotiations.  A foundation of this theory is Nash's 1950 paper that developed a model where two players bargain over the allocation of a "pie".  The solution to his paper is well-known for its elegance and simplicity:  Players will come to a decision that maximises their utility or well-being, taking into account what happens if no agreement is made.


John Nash

We compared Nash's results with Rubenstein's, whose solution, while also pretty straightforward, is much more abstract.  In his game, the optimal allocation depends on the players' relative levels of patience, i.e. their discount factor (which is analagous to their inverse discount rate).  That's where things start to get tricky.

The difference between what Nash created and what Rubenstein derived is that Nash proposed something simple but realistic, in which caveats could be revealed and explicated.  Sure, Rubenstein generalized Nash's results to something more "realistic", but for practical purposes, the solution to his problem depends entirely on something that can't be measured.

Anyway, just a comment.  Tricky formulas and fancy models are nice to look at, and they help make sense of a complicated world when words get jumbled, but it's important to recognize their practical limits.  Economics is useful because it explains what drives human interactions.  That's not an explicit goal of mathematics.

Peak Oil Denial

Well, it looks like Arizona Tea Party Congressional candidate Jesse Kelly thinks oil is a renewable resource.

SMDH.

It's a .gif if you click on it.

Aside from the fact that this clown is trying to replace the irreplaceable Gabby Giffords, and regardless of whether or not he was joking (he's a joke either way), this new focus on the availability of oil represents a disconcerting shift in Republican/Tea Party anti-environment strategy.  They've spent the last few years dismissing the overwhelming evidence for climate change as junk science, and now they're trying to confuse people even more.

If you're not familiar with the scientific and economic definitions of peak oil, it's easy to get confused.  Formally, it's the maximum, or peak, of the extraction rate path, i.e. when the first derivative of the extraction rate with respect to time is equal to zero.  In layman's terms, once we've discovered and developed the economically viable extraction technologies, and once we've tapped most of our known oil reserves, the price of extraction will go up, demand will go down, and the extraction rate will necessarily begin to fall.

Equally important is understanding what peak oil is not.  It's not when we run out of oil, or even when we get close to running out of oil, for that matter.  Republicans are now trying to argue that we're not anywhere close to running out of hydrocarbons, and they're right.  We have hundreds, maybe thousands, of years of natural gas that we could suck up and burn.  That's a straw man, though, because no one ever suggested that we were about to run out of oil.  Republicans know it's a silly argument, but it gives them something to talk about other than the health and economic effects of local pollution and the devastating domestic and international effects of climate change, the evidence for which would completely discredit their drill-baby-drill position if it ever enters the mainstream American dialogue.

We should be offended that they think we're so stupid.

*****UPDATE*****

Someone asked me about the math behind the idea of peak oil.  It's pretty straightforward, and I've drawn a crude graph here:

From the point where time t equals zero, which we'll assume is the exact moment humans started extracting oil, oil was being extracted (I hope this is obvious).  Intuitively, since we were extracting something as time moved forward along the bottom axis, the rate of extraction is necessarily greater than zero.  It's impossible to know exactly (or even approximately) how much oil is underground, but we know for a fact that there is not an infinite supply.  That means eventually, as time continues moving forward, the extraction rate must move back toward zero.  Thus, there has to be a trend, and it has to have a turning point.

Now, obviously in real life, the extraction rate isn't smooth, which is why I've included the thin red line to simulate what an actual extraction path may look like after including new discoveries, new technologies, etc.

Anyway, just FYI.

Keystone and China, again

Matthew Kahn at UCLA discusses the debate among economists, environmentalists and businesspeople over Keystone XL:

If Canada doesn't sell us their fossil fuel, will it really sit in the ground and not be consumed?   Global GHG emissions would be lower if such natural resources weren't tapped.  This is really an issue of transportation costs and economic incidence.  If the pipeline had been built connecting Alberta, Canada to U.S consumer destinations, what would have been the gains to trade?  In the absence of this pipeline, will this natural resource now be shipped to Asia?  At what transportation cost and what are the gains to trade?  So, does not building the pipeline have a causal effect on the dirty resource staying in the ground?  China smells an arbitrage opportunity here and is stepping in.  Have well meaning greens defended their "line in the sand" or have they merely diverted oil that will be consumed anyway?  World trade poses a challenge to the boycotters.

I addressed this issue a few months ago, but it's important to point it out again, especially as the debate intensifies in light of Obama's Keystone XL hold-up.  China would love to get its hands on all that oil (although one commenter on Kahn's post rightly notes that British Columbia would put up a fight if TransCanada tried to bisect it with an oil pipeline).

I agree with Kahn that opponents of Keystone XL - and environmentalists in general - should focus more on ways to incentivize innovation in the clean technology sector.  Economic theory tells us that we will use a resource either until it runs out or until the marginal cost of that resource exceeds the marginal cost of some alternative.  Making clean energy more efficient and less costly is the only way to go, but until then, it's important to weigh the costs and benefits of letting other countries exploit Canada's oil sands.

Getting Lectured

One of my favorite things about LSE is the number of public events that are hosted each week.

On Tuesday, I went to a lecture called "Crises and Revolutions: The Reshaping of International Development" by Sri Mulyani Indrawati, a managing director of the World Bank.  She made some interesting points about the relationship between politics and economics and how the World Bank, despite being a "non political" organization, has to recognize that money drives a lot of what goes on within governments, and vice versa.

She also talked about the importance of civic participation in the development process, and she referenced the role that protesters played in the ongoing political turmoil throughout the Middle East.  She said that a lot of people mistakenly believe that "government vs. people" is a transitional phenomenon, but that in reality, it's something that can crop up any time there is social unrest.  People are looking for "a new social contract with the government", which has been highlighted by the financial crisis. That, coupled with the Arab Spring, makes 2011 a history marker, and she thinks from now on, we will change the way we view development, with countries like China and India taking a much more prominent role.

The next lecture I attended was a Green Coffee Talk hosted by the LSE Environment Society and was, IMHO, the most interesting of the three (we limit attendance to around 15 people so we can have more of a discussion than a lecture, plus the subject matter is obviously very relevant).  Dr. Carmen Marchiori, one of my environmental economics lecturers and an expert on negotiation theory, talked about international environmental agreements, including predictions of what might happen in the future.  With environmental negotiations, countries have a strong incentive to free ride, and game theoretic models predict that only weak agreements can achieve broad consensus in an international arena.  Carmen's research explains why countries do end up agreeing to somewhat aggressive emissions abatement goals by looking at the complicated relationship between governments, lobbyists and civil society.

She has also done work on linkage strategies, i.e. attaching a stipulation for R&D funding to specific emission reduction targets.  Free-riding is always a problem, but when there is a credible and severe punishment attached to failure, countries are a lot more likely to respond (although it could have the perverse effect of turning countries away from the negotiations altogether).  

Her research predicts that, in the future, environmental negotiations will result in smaller coalitions with more aggressive abatement targets, and the focus will shift from mitigation to adaptation, which helps solve the non-excludabiliy problem that has encouraged actors to free-ride in the past.  Developing countries like China and India will be hit especially hard by climate change, and as quickly as they're emerging as major players on the international environmental scene, we can expect a lot of pressure from them to invest in adaptation projects. 

Finally, I went to a lecture called "OECD Labor Markets in the Great Recession" by Nobel Laureate (economic sciences) and LSE Professor Chris Pissarides.  I had heard he was boring, but his lecture was actually very interesting.  He specified a simple model of employment, then took the residuals from the model and explained why it was different for each country.  His conclusions were fascinating.  For example, he said that the US has really good employment laws (i.e. nonrestrictive) but that our lack of incentives to hire new people, coupled with an underfunded education that isn't preparing graduates (at either the high school or college level) for available jobs, has lead to a jobless recovery.  He also pointed to the change in labor mobility in the US, which he linked to home ownership (if people can't sell their homes, they can't afford to move and look for work), the extension of unemployment benefits with few stipulations attached, and a lack of training programs to help the unemployed find work as reasons for our jobless recovery.

This post is getting long, so I'll end it, abruptly, here.  You can dig through the LSE website to find podcasts of the two public lectures I mentioned above.  Unfortunately, the Green Coffee Talk wasn't recorded, but the interested reader can find some of Carmen's research here, although it's quite technical.

Fracking and Information Disclosure

There's a weak new rule floating around DC (in draft form) that would require oil and gas companies to disclose the chemicals they use in the hydraulic fracturing, or fracking, process - but only if they're fracking on federal land.

Of course, industry groups and some members of Congress argue that such disclosure requirements would reduce the competitiveness of firms by revealing trade secrets, but intuitively, that's not true.  There are only a few companies with the physical capital necessary to frack, and it's a safe bet that those companies already dominate the market.  It's like Wal-Mart being worried about competition from a mom-and-pop store because it had to disclose the contact information of its Chinese wholesalers.  Ridiculous.

I harp about externalities a lot, but that's because they're a main theme in environmental economics.  In case you've missed other blog posts where I define it, an externality exists when one actor's decisions impact another actor without taking those impacts into consideration.  A common example is second-hand smoke: if I'm smoking a cigar outside a bar, I've probably weighed the pros and cons for myself (e.g. lung cancer vs. looking "cool"), but it's unlikely that I considered the negative effects my cigar smoke has on all the people around me.  It's easy to extend that example to industrial pollution.

Two externalies that have been linked to fracking are ground water contamination and earthquakes.  Industry groups argue that the science is unclear, but that's the same story we've heard from the same groups concerning climate change science.  It's an old trick. 

From an economic perspective, information asymmetries are a classic form of market distortion, which prevents an efficient and optimal allocation of resources from being achieved.  With that in mind, it is the government's responsibility to correct those asymmetries by requiring companies to reveal everything they do that could negatively affect society.  That gives consumers the information they need to make rational decisions.  If consumers then decide not to purchase natural gas that was extracted via fracking, then the externatlies imposed by oil companies are internalized, and efficiency can be (theoretically) achieved.

The point is, this law should be stronger and it should be enacted quickly.