Economics of Flu Vaccines

In the last few months, the H1N1 influenza virus, or “swine flu,” has been dominating the news, and many people are worried about access to flu vaccines or “flu shots.” (That is, unless you work for Goldman Sachs, who got first dibs. But don’t they always?)

Unlike other viral diseases, flu viruses constantly mutate, or change into new “strains.” A vaccine that works to protect against a specific strain one year will probably not work to prevent against a new strain the next year. Because of this, hundreds of hours of lab work are devoted each year to identifying specific flu strains, developing a vaccine against them, and then producing that vaccine in large enough quantities to distribute to the population.

This year, the efforts of flu vaccination labs have been split, with only some of the labs producing vaccines against the “regular” flu, and the rest working on vaccines against the specific H1N1 swine flu strain. Because of this, the supplies of both of these types of vaccines are greatly reduced this year in comparison to previous years.

Given the scarcity of both traditional and swine flu vaccines, how should the existing vaccine be distributed? If the goal is to maximize societal health, the flu vaccine should first be given to those whose health would benefit from it the most, who are people at risk of complications and death from the flu, including young children, the elderly, and the immuno-compromised. On the other hand, if the goal is to minimize the cost of the flu to an economy, the most productive and important members of society should get the first vaccine.

To a certain extent, extreme examples on both ends are small in number and easy to take care of. For example, health care employees are at greater risk of contracting any disease and, consequently, of infecting those whose health is vulnerable. So it’s clear they should be the first in line to get the vaccine. But what about people who don’t have such critical jobs (and keep in mind that you probably qualify as one of these people)? This topic relates not only to the health of the economy, but your personal health as well.

Discussion Questions:

1. Do you think that the goal of those who control flu vaccine policy should be to get the best health outcome, to minimize the cost to GDP, or some combination of the two? What public health policies would achieve your preferred policy goal?

2. Assume that society does want to maximize productivity in dollar terms rather than health outcomes. Now, take into consideration the fact that those who do get sick might require expensive medical treatment, the cost of which will be partially borne by society. How does this alter the analysis of who should receive the vaccines?

3. Economists often are fond of markets as allocation mechanisms because the forces of supply and demand determine a price that allocates goods to those who are willing to pay for them the most. How would a market for flu vaccine work? Why is it different from a market for non-life-affecting goods and services, like books or cars?

4. Firms (especially ones with high-productivity employees) value their employees’ health. It is estimated that that the total yearly economic cost of the flu in the U.S. is over $80 billion. Many companies have started to recognize this and have made attempts to protect their own economic interest by paying for or providing flu vaccines to their employees. As a result, employees who otherwise may not have been vaccinated (since the unsubsidized cost exceeds the expected health benefit) are more likely to accept the free vaccine. Is this efficient? Is it equitable?

5. Vaccines have a limited shelf-life – that is, they can only be used for a particular period of time if they are to be effective. For this reason, the timing of development, production, and distribution of flu vaccines in the United States is largely based on the pattern of the flu season in previous years. Go to Google Flu Trends to see a graph comparing the incidence of flu activity in the United States this year with previous years. How does the current flu season differ from previous years? If you were in charge of setting production policy for 2010, what might you change in order to produce the correct amount of vaccine for each strain of flu at the appropriate time?

Leggo My Eggo! Really!

It’s hard to miss the barren shelves in grocery stores due to a pending Eggo Waffle shortage. The recent run on the popular breakfast food is one of the few times when a very clear-cut piece of microeconomics hits home enough to capture the attention of people without an economics background. What fascinates me the most about this story is how people with no interest in economics still have the shortage on the tips of their tongues. I believe there are two different microeconomics concepts at play here: one covered in nearly every introductory economics class and the other a deeper assumption that deserves more discussion than it normally gets.

First, the shortage in stores essentially comes from Kellogg’s self-imposed price ceiling. It seems that Kellogg has decided to continue selling Eggo Waffles at the same manufacturer’s suggested retail price (MSRP) rather than raising it to reflect a decrease in supply since two of their four production plants are out of commission. By leaving the price where it is, there is a shortage in the market because more people would like to buy at the MSRP than Kellogg wants to serve. This decision seems odd to economists because it introduces inefficiency. The price ceiling creates a shortage in the market which leads to the inefficiency. On the corresponding graph, you can see the minimum amount of deadweight loss (DWL) in the market for Eggo waffles given this shortage; the DWL could be larger if those consumers with a lower willingness to pay are the ones who end up buying the existing waffles. One possible reason for the price ceiling is that Kellogg does not want to appear like it is trying to profit off of its own misfortune (the Atlanta plant closed due to heavy rain) and planning (the Tennessee plant closed for repairs).

Operating under typical economic assumptions, unless Kellogg or individual stores decide to raise the price, the shortage in grocery stores should continue. This means that some consumers who would be willing to pay more than the MSRP will be unable to get waffles. Which customers end up with the waffles will only be a matter of timing and luck, and it is very likely that some people who are unable to purchase waffles will value them more than others who buy a box they find on the shelves. One common explanation economists offer about how this situation will be resolved is the emergence of a secondary market or black market. USA Today interviewed Joey Resciniti, a shopper who bought one of the last boxes, who said, “I told my husband that maybe I need to put them on eBay." In secondary markets, people who are lucky enough to buy the boxes at the MSRP are able to turn around and sell them to an unlucky person who is willing to pay above the sticker price but was unable to buy any waffles in the store, exactly what Ms. Resciniti suggested.

The second economic concept at play here is the competitive hypothesis. The classic supply and demand analysis used above rests on some core assumptions of economics, such as rationality of agents, complete information, and the competitive hypothesis. When any of these assumptions are broken, we need a different model to understand what will happen in the world. The competitive hypothesis can be summed up by the assumption that a consumer believes that if they decide to buy a product they can afford, they are able to get it. For example, if I worried that the gas station near my house would run out of coffee before I get there in the morning, I might behave much differently. The same can be said of Eggo Waffle consumers. In the USA Today article, Ms. Resciniti also said, "We have eight of them, and if we ration those—maybe have half an Eggo in one sitting—then it'll last longer.” If consumers believe they will have a hard time finding an item they want to buy, they may instead chose to change what they want to buy. If for example, Ms. Resciniti does start to ration her waffles, then she may need to buy more oatmeal or fresh fruit for breakfast on other days. If consumers start rationing because the competitive hypothesis does not hold, a more complicated model is needed to correctly determine equilibrium behavior.

Discussion Questions:

1. What should the shortage of Eggo Waffles do to the demand for other brands of waffles? What about the demand for maple syrup?

2. Think of some secondary markets you are familiar with, like eBay, ticket scalpers, or craigslist. How are prices determined in these markets? If a secondary market for Eggo Waffles forms, what can you say about the equilibrium price?

3. If a black market for Eggo Waffles did emerge, who would be worse off at the equilibrium? Would anyone be better off?

4. Think of some other real-world examples where the competitive hypothesis is violated. What would need to be added to the basic supply and demand model to accurately predict what people do when they aren’t sure if the store will have the goods they want in stock?

Internet by the Byte

With significant contributions and analysis from Kasie R. Jean.

Many existing industries follow a pay-per-use pricing structure. Cell phone companies typically charge by the minute and taxi cabs charge by the mile—why should Internet usage be any different?

Time Warner took the pay-per-use approach recently when it announced a pilot pricing model for its broadband Internet service. The new tiered billing system resembles that of most cell phone plans: households choose one of five levels ranging from 5GB ($29.99) per month to 40GB ($54.90) per month (or a yet to be priced 100GB per month) with a $1 fee for each GB over the chosen plan.

For flat-rate customers, Internet bandwidth is like a common resource—everyone can use the Internet as much as they want, but when one person uses a lot of bandwidth, that slows down the service for everyone else. This is a practical example of what economists call “the tragedy of the commons.” The argument claims that heavy Internet usage imposes a negative externality on all users who share a provider. In order to control its product quality, Time Warner tried a tiered pricing plan in hopes that it would discourage large bandwidth users from bogging down the service’s speed. By adding a cost, Time Warner caused consumers to internalize the externality imposed by heavy Internet usage under the flat-rate scheme.

So, what's the downside? There isn't one, unless you happen to be a consumer whose usage puts you in a tier that's priced above the current flat rate. More and more people find themselves in this group as the Internet’s functionality expands. Nowadays it is not uncommon for consumers to work from home, stream episodes of TV shows that they missed, download music, or play video games through their PC console on systems such as the Xbox or Wii. Streaming and downloading are a surprisingly quick way to run through your monthly GB quota in a matter of days.

Suppose that you used to pay a flat rate of $39.99/month with Time Warner. Under the new pricing system, this same monthly fee would entitle you to only 10 GBs/month. A few movie downloads and streamed TV shows later, and you will already have run through your monthly usage allotment and will be stuck paying overage charges for routine Internet tasks.

It's not surprising that the trial runs of the tiered pricing system caused a major uproar among Time Warner users. Under the proposed new pricing, any users consuming more than 10GB’s per month will be paying more for essentially the same service (though access might be faster if the new policy is a successful deterrent to over-use of bandwidth). If Time Warner decides to go through with the pricing switch nationwide, only the very low bandwidth users will actually benefit from it, which will potentially cause a mass exodus from Time Warner to other services.

Discussion Questions

1. Under the newly proposed pricing model, is the overage fee always something consumers should choose to avoid? If you knew you would consume exactly 8GB of bandwidth next month, what is the least cost way to purchase it? Construct a graph that shows the least cost way to consume at any monthly usage.

2. Switching costs play a significant role in the market and pricing structure of an industry. How do switching costs affect Time Warner’s ability to change its pricing scheme with current users?

3. How do consumer preferences and alternative Internet services affect the decision to choose one service or another? Which consumers would prefer a tiered pricing system over a flat rate system?

4. Suppose the new pricing goes into effect. Since video streaming is bandwidth intensive, how might a website (like YouTube) or a service (like Xbox Live) be able to keep its current users?

ARRGGHH... The Stakes Be High, Says I!

When you pay ransom to a hostage-taking pirate, traditional economic theory suggests that you increase the returns to piracy, encouraging more of it. If you kill a hostage-taking pirate, you increase the cost of piracy, which should discourage would-be pirates from taking to the seas.

The response by the Somali pirates to the U.S. Navy's recent killing of three pirates has been just the opposite though. These gangs say they are now devoted to revenge-taking over more ships and taking more hostages than ever. The cost of doing business has risen, and yet they want to do more of this business than ever. Why do you think this is?

Discussion Questions

1. In order to quickly obtain large ransoms, pirates must signal a credible threat to cargo ship owners. How might this credibility issue play into the pirates' response to the actions of the U.S. government?

2. The pirates killed by U.S. Navy snipers were holding an American captain of an American boat with an American crew. Might governments respond differently in situations involving multi-national crews?

3. The pirates who were killed were likely just henchmen with little power in the criminal organization. Did the "cost of doing business" really rise very much for the pirates running the organization?

4. In what ways does the government provision of naval security in international waters resemble a public good? Might the current allocation of security (both private and public) in international waters be inefficiently low?

5. From the standpoint of ransom maximization for a small individual gang of pirates, what is the optimal amount of piracy? What is the ransom maximizing strategy if the piracy off the Somali coast is coordinated by a cartel of gang lords?

Ireland's Plastic Bag Tax

In an important scene from the 1999 movie American Beauty, two characters—Jane and Ricky—watch footage of a plastic bag dancing in the wind. That there's beauty all over the place, even in garbage, seems to overwhelm Ricky: "Sometimes there's so much beauty in the world, I feel like I can't take it, like my heart's going to cave in."

Unlike Ricky, Dubliners have to live without the heartbreaking splendor of airborne garbage. Plastic bags nearly disappeared from Ireland's cities after the government began taxing them in 2002. The tax, 33 cents per bag, was enough motivation for most shoppers to replace plastic bags with reusable cloth bags. Ireland's experience illustrates a basic principle of taxation: if you want less of something--like the not-so-biodegradable, sewer-clogging plastic bag--tax it. Read Elisabeth Rosenthal's New York Times article to learn more about Ireland's bag tax.

Discussion Questions

1. There's nothing like a green tax to bring out our inner-environmentalists. As Rosenthal points out, after the tax passed, plastic bag use became socially unacceptable in Ireland. In what way does the tax lower the barrier to adopting a disapproving attitude toward plastic bag use?

2. Ohio issues yellow and red license plates to drivers convicted of drunk driving (apparently, Ohio officials didn't give much thought to tourists from the great state of New Mexico). Can you think of other situations or even laws that are governed largely by the threat of disapproval from others?

3. How is the Irish government's campaign against plastic bags similar to government campaigns against tobacco? In what ways do cigarette and plastic bag taxes increase efficiency for society as a whole?

4. Taxing bad behavior can be good, but implementation and enforcement are issues. It'd be relatively easy to cut down on paper waste from ATM receipts because the fee can be collected electronically at the site of the transaction. Why does a plastic bag tax that works remarkably well in the digitized supermarkets of Ireland run into implementation problems among the vendors and mom and pop shops in China?

Labels: Taxes, Incentives, Market Failure, Externalities, Environment

Too Darn Hot

It’s 85 degrees and sunny on this October day in the Bay Area, and this morning’s review of the New York Times brings a trio of stories related to heat: the tragedy of the fires raging in Southern California; a long article in the Magazine section on decreasing supplies of fresh water due to global warming; and a really interesting article on the effect of lower water levels in the Great Lakes on shipping. There are lots of good economic applications in all three of these articles.

It’s clear that there are winners and losers from warming. For example, the people who lose their homes in Southern California—and their insurance companies—are clearly losers. But others win—think of the windfall that’s about to benefit construction companies in Southern California, which were suffering recently because of the downturn in the housing market. Don’t the fires create rebuilding jobs for them? And don’t they, in turn, spend that money, benefiting others? Could we view the fires as a stimulus to the economy? Maybe there’s insufficient drought in the world after all!

If this argument rings false, that’s because it is. To see why, read one of the most brilliant three-paragraph synopses of economic theory ever written: the first application in Economics in One Lesson by Henry Hazlitt. (Clicking to the next page, “The Blessings of Destruction,” is also worthwhile. Oh, heck, just read the whole book—it will take you an hour.)

Discussion Questions

1. Suppose we assume that global warming is caused by humans, and that it is an example of the tragedy of the commons: everyone suffers because of global warming, but nobody has an individual incentive to stop the behavior that causes it. As Economics in One Lesson demonstrates, Hazlitt was skeptical of government interference in markets beyond the enforcement of property rights. Can you think of any appropriate responses to global warming that involve little to no government interference?

2. Suppose we assume instead that global warming is not caused by humans, but that humans can do things—for example, produce less carbon dioxide—to reduce its effects. How does that change your response to question 1? Does it, in fact, change your response? Why?

3. The article on the Great Lakes says that “for every inch of water that the lakes lose, the ships that ferry bulk materials across them must lighten their loads by 270 tons—or 540,000 pounds—or risk running aground, according to the Lake Carriers’ Association, a trade group for United States-flag cargo companies.” What effect is this likely to have on the structure of the shipping market in the short run and the long run?

The 2007 Nobel Prize: Mechanism What?

The 2007 Nobel Prize in Economics went to Leonid Hurwicz, Roger Myerson, and Eric Maskin for “having laid the foundations of mechanism design theory.”

Mechanism design isn’t covered in the typical introductory economics class. The narrative of your first econ class usually goes something like this: “The ‘invisible hand’ of the free market is the most efficient way of answering the fundamental economic questions: what to produce, how to produce it, and who consumes it. Sometimes the market doesn’t work—for example, in the case of externalities or public goods.”

In short, a single mechanism—the “market”—is usually the topic of discussion for intro courses. But there are lots of other mechanisms for answering these fundamental questions. And unlike the market, which is a decentralized mechanism (meaning it is not run by a central authority), there are plenty of man-made institutions that are centralized mechanisms. One example of such a mechanism is an auction, which allocates goods according to bids. Another is a political election, which allocates political power according to the preferences of the electorate. Both auctions and elections have rules, and these rules determine the optimal behavior of bidders and politicians.

One of the biggest challenges of designing an economic mechanism is that people have private information about their own preferences. One of the most famous examples of a mechanism design problem is the provision of public goods. Suppose a small town is considering the establishment of a public park in the town square. Should it ask the citizens how much each of them would value the park, and ask them to contribute that amount? Clearly, each of the citizens would have an incentive to “free ride” on their neighbors by understating their own value of the public good—so as a mechanism, just asking for voluntary contributions leaves a lot to be desired.

We will be creating a news analysis assignment about mechanism design for professors who use Aplia in their classrooms. In the meantime, here are some discussion questions to get the ball rolling.

Discussion Questions

1. “Market failure” often occurs when dealing with things other than purely private goods—for example, public goods, common resources, or goods with externalities. One solution to market failure can be broadly categorized as “market solutions.” An example of such a market solution is the levying of a Pigovian tax, which keeps the basic mechanism of the market but alters the incentives of participants. Another solution to market failure would be to replace the market with another institution entirely. For example, the right to use a specific frequency of the wireless spectrum is allocated by the Federal Communications Commission using an auction mechanism. Can you think of other examples of market failure that we address by using centralized mechanisms? What are the advantages and disadvantages to centralized mechanisms as opposed to market solutions?

2. The term “asymmetric information” refers to cases in which parties hold private (or hidden) information about their preferences or costs. One of the core challenges of mechanism design is to encourage people to reveal their private information in a truthful and credible way. For example, it is easy to show that the optimal strategy for a bidder in a Vickrey auction like eBay is to bid one’s true value. Think of a situation in which asymmetric information causes problems. What kind of mechanism could you design to elicit truthful information from the participants in that situation?

3. A recent Washington Post article has provoked a fair amount of discussion about the effectiveness of torture in acquiring information from prisoners. The most heavily quoted passage of the article reads:

“We got more information out of a German general with a game of chess or Ping-Pong than they do today, with their torture,” said Henry Kolm, 90, an MIT physicist who had been assigned to play chess in Germany with Hitler’s deputy, Rudolf Hess.

What do you think the economic study of mechanism design would have to say about torture? Is it an effective method for eliciting private information? How would an economist interrogate a suspected terrorist?

Financial Contagion in Credit Markets

The ongoing U.S. subprime credit crisis has received significant attention from the domestic media and even here on the Aplia Econ Blog. However, recent developments suggest that this credit crisis might be spreading to the rest of the world. Around the globe, a credit crunch is being felt in subprime markets, as well as in safer prime mortgages and leveraged lending. The World Bank defines financial contagion as "the cross-country transmission of shocks or... general cross-country spillover effects," but notes that the term is generally used to describe the spread of financial crises. Distress in one country's financial system can be "contagious" and spread to other countries whose interests are tied to the "sick" country.

When a financial crisis begins to take hold, the old saying goes that "cash is king," leading investors to sell off securities and flock from risky positions. The result is depressed stock prices, lower Treasury yields, and higher default spreads. Default, or credit, spreads are the additional premium investors require to hold a security based upon its default risk. According to the article, many carriers of the crisis "bug" are credit hedge funds that face rising leverage due to falling collateral values, illiquid markets, and tighter lending policies from brokers. Leverage exists when investors finance their investments with borrowed funds (debt).

The effect of financial contagion is stronger the more institutions and investors in different countries have vested interests in each other's financial markets. These interests may be direct equity or fixed-income investments, or they may be complex financial arrangements (which may or may not be collateralized), such as interest or exchange-rate swaps, or arbitrage portfolios designed to profit from market imprecision.

A famous illustration of the effects of financial contagion is the case of Long-Term Capital Management (LTCM), a hedge fund founded by bond guru John Meriwether whose board of directors included Nobel laureates Myron Scholes and Robert Merton. LTCM's fixed-income arbitrage strategies provided investors with astonishing returns over its first few years, until a series of unfortunate events in 1997 and 1998 crippled the fund. The collapse of the Thailand property market spread throughout east Asia, causing panic and massive selling as market volatility soared to record heights. LTCM believed it was properly hedged to weather the storm—as long as the Asian crisis was an isolated event. Unfortunately, it wasn't: in August 1998, Russia unexpectedly refused to honor its international debt, causing investors to flock toward liquidity in the U.S. Treasury market. The real effect of these crises was to cause investors to take cover from losses and to cause markets to behave in unprecedented ways.

Discussion Questions

1. Interest rates are supposed to reflect an investment's risk. Why is it, then, that in a financial crisis (like the current subprime fiasco), Treasury yields actually go down?

2. What might be a larger concern regarding contagion if it extends beyond financial markets?

3. Why does a financial crisis that causes depressed stock prices and asset values also cause investors' and institutions' leverage to increase?

4. The effect of leverage can be quite staggering, as seen in the case of LTCM, whose ratio of assets to liquid capital reached 30 to 1 in the middle of its meltdown. Suppose you run a hedge fund that leverages a $20 million equity investment into $100 million of managed assets. If poor market conditions cause your fund's managed assets to decline in value by 5%, the new value of managed assets becomes $95 million. But what is the percentage decline in value of your fund's equity position?

5. Drawing from the previous example, imagine now that your fund is even more leveraged, and the $100 million in assets is supported by only a $10 million equity position. Now what is the percentage decline in your fund's equity position due to a 5% decline in the fund's managed assets?

A Failure of Markets?

As everyone learns halfway through their first principles of economics course, sometimes markets "fail." Many economists argue, however, that the so-called failure of markets is just the reverse: it's the fact that there aren't enough active markets to reach an efficient outcome.

But can there be too many markets? Consider the latest problem with the housing market. In the good old days, when you took out a loan to buy a house, you had to convince the lender that you were creditworthy. After all, if you defaulted on your loan, they would be the one holding the bag. So they had a strong incentive to make sure that you could make your monthly payments.

This isn't the way loans work anymore, thanks to a financial innovation called mortgage-backed securities. What happens is this: when a homebuyer takes out a loan from a bank, the bank bundles that loan with many other loans to create a kind of mutual fund—except that instead of containing stock from hundreds of companies, this fund includes the debts (mortgages) of thousands of homeowners. The idea is simple: as with any mutual fund, even if a single homeowner defaults, it has a negligible effect on the value of the overall fund. The fund's price should reflect the overall risk of all the homeowners rather than the particular risk of any one homeowner.

This notion illustrates the concept of diversification—the fact that although one borrower may have considerable risk, much of that risk is unique, or diversifiable. A well-diversified portfolio of mortgages is only subject to systematic, or non-diversifiable, risk, and its value should reflect that. In other words, with a new kind of security and a market for it, the capitalist system becomes more efficient, because it spreads borrowers' risk across a wide class of investors rather than concentrating it on single lenders (banks, in this case).

So what's wrong with this picture? Think back to the initial lender. They know that they're not making a long-term loan—all they're doing is making a loan that they're then going to sell in this new market. Once they've sold the loan, their exposure to the loan's risk is over. Therefore, they have little incentive to see whether a homeowner can actually afford the payments, because they no longer bear responsibility for the credit decision. Quite the reverse, in fact: they have an incentive to sell the mortgage even if the homeowner cannot afford the payments—for example, by setting a low teaser rate that starts out fixed, but then balloons into a drastically higher variable rate. This has been one root cause of the various scandals about predatory lending practices that have been in the news in the last few months.

In the meantime, those looking to buy a home with no money down might take some advice from Saturday Night Live:



Discussion Questions

1. The crisis in the financial markets has caused some people to lose their jobs and made it harder to apply for a home loan, causing home sales to decline, both of which are very upsetting to Jim Cramer. Indeed, whenever a bubble bursts, lots of people get hurt, or at least find themselves considerably worse off than they were in the artificially inflated world of the bubble. Suppose you were a policymaker overseeing a market in which people were prospering in a way that was unsustainable. What would you do?

2. Cramer practically begged the Federal Reserve to intervene, which it did by lowering the discount rate (though not, presumably, because Jim Cramer asked it to). Does this get at the root cause of the problem? If not, what would?

3. How should society decide who gets to own a home and who does not? What would be the ideal set of institutions that could help achieve the optimal solution to such a problem? Could mortgage-backed securities play an important role in your solution?

Cheap Gas Hurts

Economists rarely advocate higher taxes on a good or service because higher taxes often increase the price that consumers pay and lower the price that producers receive--a "lose-lose" situation for both consumers and producers. However, Pigovian taxes, which are used to correct situations in which the free market produces an inefficient result, might actually increase social welfare. Greg Mankiw, an economist at Harvard and founder of the Pigou Club, argues that such taxes are currently needed on gasoline, due to the negative externalities that accompany gasoline consumption.

A negative externality is a cost imposed on a third-party by the consumers and the producers of a good or service. Take for example, gasoline. Oil companies produce and distribute large amounts of gasoline to satisfy America's desire to drive. How does a person who uses gasoline hurt other people? First, burning gasoline emits toxic chemicals such as carbon monoxide and carcinogens that damage public health. Second, cheap gas contributes to excessive driving which wears down our country's highways and causes traffic congestion. Third, as Al Gore argues, burning gasoline produces carbon dioxide, which contributes to global warming. Fourth, as Thomas L. Friedman has argued, high oil revenues actually support regimes like Iran and Venezuela, decreasing freedom in those countries as well as our own national security.

If the consumption of gasoline imposes a negative externality, then economists say that the marginal social cost (MSC) of gasoline exceeds the marginal private cost (MPC). The invisible hand fails to bring the market to an optimal outcome because the free market equates demand and private supply, and does not take external costs into account. Ideally, the market would equate demand and social supply, but rational consumers would not take into account external costs because they feel someone else should reduce their consumption of gasoline (free-rider problem). The free market leads to an almost shocking result: the price of gasoline (P1) is below the socially-optimal price (P2), and the quantity of gasoline consumed (Q1) exceeds the socially-optimal quantity (Q2).

In other words, in a free market, Americans consume too much gas! The government may remedy the situation by increasing the per-unit tax on gasoline. Higher gas taxes would increase marginal private cost and reduce the gap between social supply and private supply.

1. In a free market, the price of gas is P1 and the quantity of gas consumed is Q1. In this case, what is consumer surplus plus producer surplus minus total external costs?

2. Suppose the government imposes a per-unit tax on gasoline that forces the market to price and produce the socially-optimal quantity (Q2). What is consumer surplus plus producer surplus plus government revenue minus total external costs?

3. An action should be taken if and only if the benefits outweigh the costs. What are the costs of the gas tax in this example? What are the benefits? Which one outweighs the other?

4. The above example assumes the government has perfect information about the size of the externality caused by gasoline. But in reality, measuring the costs and benefits (especially when it comes to things like climate change or the effects on national security) can be difficult. Does this problem of imperfect information mean we should not impose Pigovian taxes? If you think we still should impose Pigovian taxes, what does the problem of imperfect information imply about the optimal level of taxation?