Monday, July 21, 2008

Eco-nomics: Partial and General Equilibrium

Economics is often taught using partial equilibrium - studying one market and assuming away any spillover effects.  Think of the classic example of the market for orange juice - teachers may (and usually do) ask about the effect on the OJ market from something like a hurricane that wipes out half of Florida's orange crop.  When you say that input costs will increase, shifting the supply curve to the NW and thus price will rise and the quantity sold will decrease you are ignoring any other effects - like perhaps that, without a crop to pick, there will be a flood of labor supply to OJ factories lowering costs for producers.  This last example is an example of general equilibrium - trying to trace the effects of some change through all effected markets.  We don't emphasize it much in undergraduate classes because it is HARD.  It is like trying to figure out global weather - there are so many interconnections, coming up with a good model is very difficult.

I mention this because this is one reason it is very hard to say what effect the push for biofuels will have on the prices of other crops and on overall welfare.  If there is increasing demand and thus price of corn, what will happen to the price of other crops in the short and long term?  Well it depends on what is being planted and where, the magnitude of the cross-price elasticity of demand for other crops - even how new fuels will effect transportation costs.  As you can see, blaming biofuels for rapid commodities price escalation (or defending them) is dangerous business.   It is also true, however, that general equilibrium effects are often not thought about very much in casual discussions of environmental economics.  

For example, I wonder what the effect would be if there was mass consumption of Priuses (Pri'i?). On the one hand this would reduce gas consumption dramatically, but it would also put pressure on the production of all the junk that goes into the batteries.  How much energy does it take to get the stuff?  How much pollution does this create?  What about waste?  I don't know the answers to these questions, but many good ideas, when considered in mass amounts, often become questionable. 

This, apparently, is true of biodiesel.  Now that many people have converted to biodiesel the supply of used cooking oil is not keeping up with demand (despite my appetite for fish and chips).  So now what? - the economic rationale has changed, does biodiesel still make sense?  I don't know.  But I do get grumpy when good ideas in isolation are not thought about in a general context - in the general equilibrium.

One final example.  My wife and my mother were talking very admiringly about the freecycle movement and the idea that one could help the world by not buying new stuff.  Hmmm...  OK, so I am an economist and not helping my rep by taking this on - but I see a few problems with this.  First, there is a market for this stuff, from people who can't afford new.  If middle class people started gobbling this stuff up, that would just either increase the demand for Wal-Mart style cheap stuff from China of further impoverish people who are already impoverished by driving the price of used stuff up beyond their means.  To put it plainly, you are not decreasing the demand for the stuff, just shifting who buys old and who buys new.  Also, why s consumption of new stuff such a bad thing?  This adds income and thus growth to the world.  If you care about poverty, this should be reason for pause.  

This did not go over well with the wife and mother.

My apologies for the slow blogging - life has been a bit crazy.


ADH said...

The problem I have with your final analysis (freecycle) is the same one you're trying to explain above in the first two. The effects are varied and involve many links and consequent events.

An analysis of freecycling should look at overall consumption - is it a shift of "new" purchases from the rich and middle class toward lower economic strata, or a more efficient use of resources within the higher strata? Freecycling should provide savings that can be invested, spent on less resource-intensive items such as services, or it may just sustain normal levels of consumption in a time of inflation. Is the "used" market is even affected (distinguishing between people who take the time to sell their used goods and those that find it more efficient to just discard them)?

Your question about whether it is "bad" to purchase new items deserves a response as well. Of course, it is perfectly wonderful to purchase goods and services that reflect the true economic costs of those items, while it is economically and socially negative to purchase items that abuse public goods or specific communities without properly accounting for those externalities. I know you know that, but your blog is good and I feel like that question is too often posed flippantly. I too have those conversations with my partner and parents, and while they rarely have the economic vocabulary to properly make their point, it is almost always a valid underlying theory.

Patrick Emerson said...

Good points all, thanks.