Explaining the Ehrlich-Simon wager

In 1980, prominent environmentalist, and author of the book The Population Bomb, Paul Ehrlich, entered into a wager with the late cornucopian economist Julian Simon. Ehrlich saw resource scarcity as a major problem, and that with time, resource prices would begin to rise as a reflection of physical limits. On the other hand, Simon predicted that with increased human population and ingenuity, the prices of resources would continue to decline indefinitely. Based on this logic, he challenge Ehrlich with “a public offer to stake US$10,000… on my belief that the cost of non-government controlled raw materials (including grain and oil) will not rise in the long run.” They designated September 29th 1990 as the cut off date for the wager, and bet on five metals – chromium, copper, nickel, tin and tungsten. The result was that the price of all five metals dropped in inflation adjusted terms, and Ehrlich sent Simon a cheque in October 1990.

So why did Ehrlich lose the bet, when we know for a fact that there are long run physical limits to natural resources? The first reason raised by many environmentalists is that his timing was a little off. Maybe he was a few decades early in his prediction. I believe this explanation is entirely incorrect.

The second reason is Ehrlich ignored economic principles. The price of a good at any point in time only reflects its relative scarcity compared to the availability of other goods – not the absolute scarcity. If the rate of supply (aka the rate of extraction) of these metals was high, the price will be low, even if this rate could only be sustained for a few years before the total physical supply was exhausted. Ehrlich made the fundamental mistake of ignoring the rate of production. But the environmental debate of that decade did raise what has become a pressing issue in ecological economics of getting the absolute scarcity of natural resources reflected in the price.

What we know more clearly now is that the rate of extraction of most minerals and fossil fuels follows a Hubbert curve, where the rate climbs before at some point peaking, the beginning a long decline. While many suggest that the peak generally occurs when 50% of the absolute physical quantity of the resource has been extracted, this peak in the rate of supply still does not mean there will be a peak, or explosion in the price at this point.

First, consider what happens when there is a small increase in the price of copper. This makes the use of copper in production less attractive than alternatives such as fibre optics. So demand will drop as well, stopping the price from spiking. The prices cannot get too ‘out of whack’ before other adjustments take place.

Consider then if Ehrlich had wagered on the price of oil, and that the bet began in 2000, with the cut off date 2010. A year ago one would have been inclined to think that Ehrlich was a genius for predicting the price spike. But in the last few months, Simon would have got the upper hand, and Ehrlich would be on the back foot making excuses about the so called ‘credit crunch’. But what really happened?

First, the oil price spike was the result of a decrease in the rate of supply of oil compared with the rate of supply of other natural resources. But more than that, it was the expectation of a continued increase in demand in the face of decreasing supply. If you take a look at the metals, their price also spiked on the expectation of future demand and low future supply.

But the catch was what happens when the economy adjusts. These ‘out of whack’ prices cannot be sustained. They flow on to the real economy. In this case, the high cost of oil and metals made it difficult to increase production as there were few susbsitutes, so economic output slowed. Suddenly, the expectation of high future demand was replaced with the expectation of recession, and prices or natural resources (oil and metals) fell accordingly.

That’s the thing with supply constraints and physical resource limits. The general rule of thumb is that relative prices between goods are caused by available technologies. When one input is constrained, it doesn’t change the relative prices so much in the long-run, rather it changes the output level - especially if there are very few or no substitute resources.

This net result of an output reduction is due the infinite complexity of the modern economy. Estimating the embodied resources in goods has been a pursuit of the past decade, but recently it is coming to light that due to this infinite complexity, all goods have equal embodiments of all resources. A dollars worth of petrol requires an equal amount of oil to produce as a dollars worth of a massage. Thus a constraint of a single natural resource flows through to have an impact on the price of every good in the economy.

So when I previously wrote that supply side restrictions are the only way to go for improving environmental quality, it implies that economic output will be reduced. If Ehrlich knew then what ecological economists now know, he would have had a much different wager. In fact he did propose a second wager. He wanted to bet that the quality of the environment would deteriorate over the 1990s by referring to 15 different environmental quality measures. Simon declined because he believed that measuring such things did not reflect well-being. Although he did lose a wager about the price of timber in Canada, but blamed new government policies.

Is public transport for the public?

On a leisurely Saturday afternoon, I ventured down to the ferry with fiancé, child, friend and dog in tow, to take a trip across the river to enjoy a BBQ in the park with friends. I was initially impressed by the frequency of ferries – every 15 minutes on Saturday is pretty good I thought. I was not impressed by being refused entry because of the dog, nor was I impressed with the cost. $3.60 for a one zone return ticket per adult. That was even a discount from the regular cost of $4.80 on a weekday. Remember, these are the cheapest adult fares for a return ticket. For the three of us (luckily infants are free and two of us were full-time students) the cost was $7.20. For three adult fares it would have been $10.80, and if it were a weekday and three adults where headed to the park, it would cost $14.40. Does that seem a little much to anyone else?

We realised that it was cheaper to drive together in one car. Cheaper by a country mile in fact. Even with the fuel price around $1.20, the same round trip would cost less than $2 between us (and we could take the dog). It would still probably have been cheaper to take a car each!

With my economic hat on I saw the reason that the situation exists where private vehicle transport is now cheaper than public transport. Governments have spent decades (centuries?) subsidising private transport, rather than investing in public transport. You could logically argue that private cars are a form of publicly provided transport, since tax revenues are the dominant funding source for road building.

Governments must believe that public transport is not an appropriate or beneficial urban transport alternative. For if that was the case, less money would be spent on roads, and more on public transport, so that the incentives shift towards using public transport. You can’t build more roads and more public transport, and expect there to be a shift towards public transport use. By investing in both alternatives you have not changed the incentive structure – yes it is now cheaper to catch the bus/train/ferry, but it is also cheaper to drive! Public and private transport are substitutes. The more expensive one is, the increase in quantity demanded of the other. Therefore traffic jams, no parking, high registration costs, difficult licensing tests, high fuel costs, and strict vehicle emissions standards all provide incentives to use public transport (but sound like a list of things to promise if you are a government intending to lose the next election). On the other hand, new roads, improved traffic management, more parking, cheaper fuel and registration are good measures for reducing public transport patronage.

Fluoride: Medication for the masses?

The Queensland government is currently phasing in fluoride to the reticulated water supply in many parts of the State. Yet there is by no means a scientific consensus that adding fluoride to drinking water provides net health benefits to the community. While there is debate regarding the ability for fluoridated water to improve the condition of teeth, there are more broad and significant implications of the decision to fluoridate water. I aim to add some further economic dimensions to the fluoride debate.

When considering a policy decision, an economist will seek to implement only those policies whose welfare benefits outweigh the costs. Regarding fluoridation, the benefits are the potential for reduced tooth decay and any health and psychological benefits that this may encompass, as well as reduced dentist bills. The costs include the provision of fluoride to the water supply, the cost to people who suffer allergies or long term side effects of which little in known, and the costs imposed on people who wish to drink water that contains no fluoride. Some estimates put the benefit to cost ratio at 56:1.

But an economist would take one step further, and would judge this policy decision against other alternatives. What about spending the money on education? If the benefit to cost ratio is higher than 56:1, then education spending should get priority.

The question the few people seem to raise is that if fluoridation is about medication of the masses, surely there are less obscure medicines that would provide greater benefits. What about adding vitamins to the water? Maybe anti-depressants? Viagra? To an objective observer, each of these options should be open to assessment as a potential policy if the social benefits outweigh the costs.

When I have the fluoride discussion with friends, this line of reasoning, about assessing alternative medications for the water supply, is generally the enough for them to actually think deeper about the fluoride issue. It raises questions like:

• How can you medicate anyone without any prior knowledge of his or her medical history?
• Why would you spend so much on putting medication in the water when most water from the reticulated supply is not consumed by people? Only about 1-2% of water in the home is used for drinking. Do we really need to fluoridate the laundry, the toilet, and the garden?

Asking the first question should really be enough to stop water fluoridation. The second question pricks the ears of an economist. If 98% of the fluoride is wasted, surely a more cost effective alternative would be to subsidise fluoride tablets, which would ensure the 100% of the fluoride gets to the people. A misallocation of 98% of a medication alerts even the serious fluoride believer.

Even for those who believe in the potential health benefits of fluoride, using the water supply for medication delivery is wasteful, and inappropriate.

Some crystal ball gazing

If my last blog, about the peak of global oil production and a sustained fall in global production, contained an ounce of truth, some interesting trends should occur in the next year or two. First, we should see the price of oil rise again from its current price of around $60 a barrel. Second, we should see an increase in the inflation rate on a relatively global scale. (Note that in the UK, inflation is currently at 4.4%. With the base interest rate at 4.5%, the real interest rate is now effectively zero). Third, we will see a sustained decline in global output. Taken together, a recipe for stagflation. (I also predict continued volatility on financial markets as demand and supply expectations feed back on each other).

Interestingly, simple macro-economic principles can explain how this will occur if interpreted correctly. One simply has to remember that supply and demand are not independent from each other. Each drives the other in a dynamic feedback cycle. Let me try to explain.

If we use the simple aggregate supply (AS) and aggregate demand (AD) curves, we can describe what I believe has been occurring in the past two years, and will occur for the next few. Looking at the figure below, we see the intersection of AD and AS at price level P1. Taking my peak oil explanation of the current financial turmoil, we should first see slight shift to the right of the AD. This growth in demand expectations is what was been driving up the share market and commodity prices in 2005-2007. This was not accompanied by a large increase in supply as physical limits (peak oil) were being met (hence the steep AS curve). Therefore we see a rise in the price level (inflation), and we see why the Australian reserve bank lifted interest rates in that period.


In time, the realisation that these demand expectations would go unfulfilled, due to supply (output) failing to increase, demand expectations dropped, shifting the demand curve dramatically to the left. This had a huge impact on commodity prices, with large drops seen in metals prices, and the oil price, and shares prices in general.


But this is not the end of the story. If I am correct, and supply will begin a slow decline, demand expectations will begin to factor in this decline. Both AS and AD will creep leftwards. To arrest this de-growth or un-growth, monetary policy will be loosened, with the intention of stimulating investment and a growth in supply. But alas, this will not occur due to the physical limits of oil production having been reached.


Importantly, using the AD and AS graph, when this leftward creep happens, the price level remains the same. How does inflation occur in this circumstance? It occurs because the money supply does not contract as easily as output does. Additionally, the likely reaction of governments and central banks will be to stimulate demand with fiscal policy, (think of Kevin Rudd’s one-off payments in Dec), and stimulate investment in supply with loose monetary policy (lowering interest rates – remember the real interest rate is close to zero in the UK, and I would suggest that this may be the case globally very soon).

The ‘solutions’ to stagflation are simple. ‘Solution’ however is used very broadly here. If your problem is inflation and you want to stabilise the currency, you need to decrease the money supply. If your problem is de-growth, then you want to heavily invest in resource exploration and efficient production technologies. Supply constraints are physical and need physical technological solutions. In time of course, these technology changes will occur through native human ingenuity, and production will be able to increase once again. If you problem is the environment, stick with the stabilising the currency and let de-growth take its natural path.

Peak oil and the financial crisis.

We have reached the lowest oil price for about a year – down around $70 a barrel from a peak of over $140 a barrel not so long ago. Is this a sign that the theory of peak oil, that at some point the rate of global oil extraction will peak, is false, or at least is not here yet? I suggest the recent pattern of oil prices, and the financial upheaval around the world, are signs that we are very close to the global peak of oil production. I will attempt to explain why this is the case.

First we need to catch up on some economic principles. The price of a good is a relative measure, and reflects how many other resources are required to produce it. Consider a $100 pair of shoes. The price basically represents that the shoe required $100 of other resources to produce it. Such things as labour costs, materials, rents, distribution, design, advertising, and so on. A $50 pair of shoes requires around half of the amount of inputs. When the price of shoes is on the rise, it reflects increasing requirement of inputs. Thus a rising price is a sign of increased inputs necessary for production. And this also means that these inputs to production cannot be used to produce other things.

Now consider what happened to the price of oil recently. Regardless of what you believe about hedge funds, short selling, or any other financial trickery, the trend was a steep price increase for that past two years or so. This is a sign that more resources have been needed to produce oil, and were subsequently not being utilised for other production. Thus, the total production of goods in the economy must eventually drop. This is exactly as peak oil theorists would predict.

But what of the recent price drop. Again, we have to wait and see what the trend might be in the longer term, but this is also consistent with peak oil theories. The point here is that over the long term, the relative price of oil and other commodities (apart form labour) will be relatively constant. When oil becomes more expensive, so do other goods that need energy from oil in their production. Only the overall output of the economy will fall. The price spike we have just witnessed may simply have been a speculative signal based on expectations of future growth that were never going to come true.

On another note, I keep wondering that if oil is a non-issue, why the US has made such a huge sacrifice in waging war in Iraq?

If I am right, and the rate of oil production has peaked this year, or will peak in the near future, this is not necessarily a bad thing. As long as this ‘crisis’ does not provide excuses to wage wars, we can continue living a rather luxurious lifestyle with a downward trend in production just as easily as we did on the upward slope of the past half-century. In time, technology will evolve and allow us to produce more once again. For an environmental economist, peak oil is blessing for the environment. If I am wrong a global recession is a nice rest of our environment anyway.

Flow

Contemporary economists know that money doesn’t buy happiness. I take that back. Economists have trouble even defining money or happiness. But they can use stone-age tools (aka the art of regression) to ‘prove’ to us what most societies have known for millennia.

This, however, is a problem. Traditional economic thought has at its core the concept of utility - the thing that individuals try to maximise, and that we as a society should also strive to maximise. In effect, it is their best attempt at defining happiness. Economists are now struggling to get past this fundamental happiness contradiction. I would like to add some thoughts from psychology that may help our understanding, and reveal the underlying evolutionary explanation of how happiness is achieved.

I will preface this blog by saying that the majority of the views I am sharing actually come from a book called Flow: The psychology of optimal experience, by Mihaly Csikszentmihalyi. He breaks down happiness into to components – pleasure and enjoyment. Pleasure by itself will not provide us with happiness. It is the type of experience we have when we do not invest psychic energy in an activity. It is passive. Pleasure may come from watching a movie, walking in the park, admiring a work of art, listening to music. Enjoyment on the other hand requires the investment of psychic energy. The flow experience is how one gains enjoyment, and it comprises eight components:
1. Confronting tasks that we have a chance of completing
2. Concentration
3. Clear goals
4. Immediate feedback
5. Removes awareness of worries and frustrations
6. Provides a sense of control over one’s actions
7. Concern for the self disappears
8. The sense of time is altered

Clearly, a life without confronting tasks and clear goals is inherently unrewarding. But this is exactly the goal of much of societies development in the past century. The goal has been to make life easy, with no confronting tasks, and give us more choice, and as I have suggested earlier, this ‘choice-overload’ leads to less clear goals.

Surprisingly, Csikszentmihalyi found that people experience flow more often at work than during leisure time. It is easy to imagine many working environments where the first 4 components of flow are readily available. Other places people experience flow is when playing computer games. In fact, the game design field is probably the greatest user of the principles of flow. You know how you start with easy levels. You acquire greater skills, and are then confronted with more challenging tasks. All the way, there is plenty of feedback, and two hours have gone by in a flash. Edward Castranova has written about how people are shifting from their real lives, into online gaming worlds in search of flow.

One of the most interesting parts of flow is that to continue to have flow experiences, you need increasing complexity of challenges, and of skills to meet them. As a society , we have basically taken away much of the challenge of living, and also taken away many of the skills necessary to learn in order to live. Many people cannot cook themselves a meal from fresh ingredients. They cannot mend their own clothes, repair their houses, cut their own hair, clean their own house – what skills do we have?

I would to propose an evolutionary explanation for this desire for flow. In essence, those who sought more challenges, and reached them, were rewarded. You can imagine a tribe of early humans seeking out new lands in the face of increasing numbers of predators. The reward for this desire to rise above challenges, and persevere until new lands are found, would be greater reproduction and survival rates. Those early humans who did not have this desire to confront challenges, would ultimately perish before they could reproduce.

The ironic part of all this, is that flow often occurs in the times of most hardship. Csikszentmihalyi found that many prisoners of war, and people who have were faced with major physical disabilities, actually experienced flow more often than those of us living cushy urban lives in the 21st century. While we may find much pleasure in our comforts, this will not bring us happiness.

So what can we do to increase flow? We need to acknowledge that the most vital part to this story is that flow actually is self-determined. You can actually learn to be happy. External factors play no role. It is how you interpret your external environment that determines your happiness.

With all this great detail about human motivation and happiness, I still wonder why economists seek explanations use outdated concepts like utility to explain our actions. By sticking with this underlying theory they are stuck with trying to see whether factors such as wealth, number of children, marital status, age or any number of external circumstance or events can provide happiness. They pursue this even though they know can never prove a casual link. I guess reality and economics don’t mix sometimes.

New wikipedia entry

Just a short note this time.

I have written a new wikipedia entry for the Rebound Effect - which many of you would know is the topic of my thesis. If you are interested in a brief summary of what I have been spending my time on this past year, take a look.

http://en.wikipedia.org/wiki/Rebound_effect_(conservation)

The Tyranny of Choice

No, the title is not original and there is a good reason for this – choices have long been a source of concern for many people. And in recent years, choices have grown at a rapid rate. The question posed by Barry Schwartz, author of the book The Paradox of Choice, is whether all this choice has improved the welfare of society. Or, as he suggests, has the dazzling array of choices put as all at a disadvantage. How does this paradox occur?

First imagine choosing an ice-cream flavour. First you go to a store with only chocolate and vanilla. You weigh up the benefits of each flavour against the other, and make a choice. If you choose chocolate, vanilla is what economists term the opportunity cost. It is the forgone alternative for making a decision. Every time we make a choice, not only are we choosing one alternative, we are choosing to forgo another.

No let’s consider an ice-cream store with 30 flavours. To make a decision here, you need to weigh up the benefits of each of the 30 flavours to decide which is preferred. This is no mean feat, considering the likely limitations in knowledge of each of the flavours. When we decide, the opportunity cost of the decision is any one of the 29 other flavours we have forgone. And quite simply, the more alternatives we forgo, the less likely we are to be assured that the decision we made was the best alternative. In fact, people are much less happy with the decision they made when there are more alternatives, even if it is definitely the best one for them. This is because there is only a slight benefit over the second best alternative, and people only judge outcomes on this marginal benefit.

Also, if we compare ice-cream flavours in a pairwise manner, which means comparing two at a time, to determine our preferred flavour, we end up with 2¬30 small decisions to make, equal to the one we made at the previous store when we only had to decide between chocolate and vanilla. This can often lead to decision paralysis, where we simply avoid the choice because the process of making a choice itself is such a burden that the ice-cream will not make up for it.

Decision paralysis can bee seen widely in everyday life. At the moment, a friend of mine is visiting from abroad, and is trying to make a choice about his direction in life. Because there are so many options to choose he cannot pick one over the other, and when he does choose, there will be a second best alternative very close to as good as the one he takes, which he will always compare himself to.

In behavioural economics experiments it has been clearly shown that too much choice is a hindrance. For example, consider those free taste tests you sometimes get at the supermarket. It has been shown that it is best not to give too many options. The taste tests that give less than five varieties get more people to buy any one of them than taste tests with ten or more varieties. Also, companies that offer only three or fewer alternative health insurance plans to their employees in the US, get a much higher uptake in insurance than those who offer between ten and thirty different plans.

This leaves us in a tricky situation. If we only derive satisfaction from the benefit we get from a choice compared with the next best alternative, than too much choice is bring down human welfare. It is making us unhappy. But is there an optimal amount of choice?

Valuing the apples and bananas

It has come up for discussion in blogs, at bbqs, and international conventions, but we are still no closer to a workable solution for valuing the environment. When I say environment, what I mean specifically are natural ecological systems. And when I say valuing, I mean determining the contribution of these systems to the welfare of humanity. The difficulty for environmental economists is determining the value of these ecological systems in a common measure with the value we derived from conventional consumption – that is, in dollar terms. If we can establish a value for the environment it becomes a simple procedure to evaluate the human welfare implications of any land development.

So how do we go about comparing apples (the welfare we gain from the environment) and bananas (the welfare we gain from consumption)? One approach often used is to estimate the contribution of one particular ecological service, for example pollination by insects, to the economic production (http://news.mongabay.com/2008/0916-pollination.html). But this conventional approach estimates the contribution of ecological services to the production of real goods – in the pollination example, the contribution to agricultural production. By this only tells half the story. It tells the banana story, as it only looks at the value to production. The apple story is the welfare we gain from pollination in terms of its role in ecological systems that provide us with clean air, water, and any other non-economic way it which it improves the human experience. We cannot maximise human welfare without an estimate of apples and bananas.

The only reason we have certainty that conventional consumption (the stuff money can buy) provides us with increased welfare is because we are willing to pay for it. If we are voluntarily willing to give up other consumption for consumption of that good we must be benefiting. But if we take this willingness to pay principle to the environment, we face some hurdles. First, imaging your willingness to pay for a day’s breathable air. For me, it is almost infinite (if there is no alternative way of getting breathable air). Then we can look at water. A man dying of thirst in the desert would pay his life’s fortune for a little clean water. So in a way, we could say that these environmental services we get each day for free are infinitely valuable.

But most of us still receive these free environmental services each day even though we have severely disrupted the ecological systems that support it. So how do we know whether development that destroys ecological systems leads to a reduction in the welfare?

These are just some of the hurdles we face when trying incorporate the value to humanity from the environment into consideration. If you know of other concerns, please let me know. This is a big topic that will be the focus of much future research.

Too fat to fail

I remember a quirky line from Richard Branson’s autobiography. It went something like this – if you borrow $40,000 from the bank and can’t repay, it’s your problem, but if you borrow $40million and can’t repay, it’s the bank’s problem. He was talking about borrowing to buy planes for Virgin airlines, but a similar principle applies in so many places – the larger your business, the more people who have an interest in keeping it going. This includes the lenders but also the employees, other firms that do business with you, and the customers.

The reason I raise this point is because of the US Federal government bailout of Freddie Mac and Fannie Mae - both private firms dealing in the secondary market for mortgages. While Fannie Mae is a former government agency, and was privatised in 1968, Freddie Mac is a wholly private company, chartered by the US congress in 1970 to provide competition in the secondary mortgage market. All assets of these companies are solely owned by the shareholders, who also reap the profits from their investment.

So we see an interesting dilemma. For an economist, competition between producers provides great benefits to society by responding to demands and pushing down prices. However, inherent in this competitive environment is that businesses will occasionally fail. Problems arise when firms become very large. You can imagine that if the Queensland bank Suncorp went broke – that’s 9000 people out of a job, not to mention the problems with people who are insured by them, and flow on effects to other businesses.

I think economists often forget that their model of perfect markets is far removed from reality. In this model there are a large number of buyers and sellers, and no barriers to entry. Any market with few players and high capital costs is not perfectly competitive. If a firm fails in these oligopolistic markets there can be quite a degree of social disruption. Governments see these social costs as motivation for bailing out large firms. The US, an icon of capitalism, has probably the worst track record for corporate bailouts, with the airline industry post 9-11 another example.

What is most interesting about the bailout of the two secondary mortgage market players is that the intention is to prop up the whole economy. But you don’t see the government propping up the family fish and chip shop, or the local grocer, even though that is their intention in the end. One must wonder what criteria is used to determine whether a corporate bailout will or will not occur.

It is a surprising that any government would go ahead and privatise an industry if they are going to guarantee the newly created private firm against bankruptcy anyway. One criteria for privatisation much surely be that the firm be allowed to go bust. In any case, the issue over excessive scale of corporate enterprise, to the point where failure of the firm creates massive social disruption, should be an issue for governments worldwide.

Any thoughts on this type of government involvement in private enterprise?