The Business Case for a Carbon Tax

 

Economists say a carbon tax is our best bet to slow global warming, but business groups have lobbied hard to keep such a policy from being enacted. A new study examining the impact of carbon pricing on markets suggests the opposition is understandable — and wrong.

To see why, take a look at all those pickups and SUVs at your local mall. With pump prices down 30 percent since 2011, lumbering around the suburbs in an off-road-ready vehicle seems cheap. Thing is, it’s not: Carbon emissions from tailpipes contribute to climate change, which has a huge and very real price tag. But it’s not money out of drivers’ pockets.

Carbon tax corrects fuel prices to reflect the true cost of drivingIt’s the same for companies that rely on transportation to deliver raw materials and distribute their products; in designing their supply chain, they’ll take into account any costs they pay, but not the costs they impose on others by polluting the air.

That’s called a “negative externality,” a situation where the prices faced by buyers are less than the value of the resources they use up. When that happens, choices that seem rational to each of us individually add up to lousy outcomes for all.

The best way to fix that, economic theory tells us, is to internalize the costs — in this case, by adding an offsetting tax to fuel prices. However, opponents like the U.S. Chamber of Commerce say the theory ignores the pressures of competition. A carbon charge would raise production costs, they argue, and could put some companies out of business.

Scare tactics? Not at all, says Guoming Lai, associate professor at the McCombs School of Business. “That’s actually true. But the country as a whole would still be better off.” And as this study shows, the benefit is larger, not smaller, in competitive markets.

Social welfare definition sidebarWhat Does it Mean for Commerce?

To find out how a carbon tax affects businesses, Lai and his coauthors — Seung Jae Park of Texas A&M University, Wharton’s Gérard Cachon, and Sridhar Seshadri from the Indian School of Business — modeled the case of rival retail chains selling a staple like groceries (think of Safeway, Kroger, and so on).

In the model, firms have to decide how many stores to open and where; more outlets means a higher market share but also more trucks driving around to keep the shelves stocked. Then, given the distance to the nearest store, consumers decide how often to shop. Both choices hinge partly on transportation cost, which goes up with an emissions tax, and firms can exit the industry as the market adjusts.

Using this framework, the researchers examined the impact of a carbon charge under a range of market conditions, from monopoly to oligopoly (a mix of dominant and weak firms) to intense competition (identical firms). In each case, a policymaker determines the optimal tax rate to maximize social welfare.

Compared with earlier studies that ignored the role of competition, “our model considers more realistic market structures,” Lai says. And it recognizes that firms don’t just cut their output when costs rise, as in those simple supply-and-demand diagrams we all learned in Econ 101; they might also restructure their operations.

No Pain, No Gain

When the researchers ran the numbers, they found that a carbon charge does cut into profits, due to the added expense and the fact that taxed consumers have less money to spend. Still, society as a whole is better off in every scenario, as the benefits of lower emissions outweigh the burden on firms and consumers.

What’s more, it turns out that the net gain is much larger in vigorously competitive industries with lower profit margins (like supermarkets) than in monopolies (like, say, electric utilities). “The sharper the competition, the greater the benefit of the tax,” Lai says. That’s an important result because competitive markets are the norm in the U.S. economy.

Not that there wouldn’t be gnashing of teeth. Under competitive pressure, the researchers find, taxed firms are indeed forced to alter their supply chain — in the model, that means changing the number and location of stores — and less carbon-efficient companies may go out of business. But far from being an argument against a carbon tax, Lai says, that’s what makes it work.

Correcting Energy Prices

The reason, he explains, comes back to externalities. We always think of competition as the most efficient way of allocating resources. But when firms can freely tap the finite resource that is our common atmosphere, the invisible hand of the market makes a mess of things.

Thus, in the absence of carbon pricing, artificially cheap transportation leads to inefficient retail networks. You’ve seen it: Rival supermarkets, battling for share, open stores across the street from one another. Now you have two supply trucks driving to the same location (and idling their engines in the lot), where one might have served the volume of sales in that area.

A monopolist, of course, would never open two stores in the same place. Crazy as it sounds, in the presence of externalities, the competitive industry is more wasteful. “The carbon tax is more beneficial under competition,” Lai says, “mainly because there’s more room for improvement.”

When firms can freely taop the finite resource that is our common atmosphere, the invisible hand of the market makes a mess of things.

So yes, some firms might vanish as an industry consolidates, but the hard truth is they’re getting a free ride today. A carbon tax simply corrects fuel prices to reflect the true cost of driving, and if an enterprise can’t pay its own way, most of us would say it shouldn’t be in business.

That said, nimble companies could also adapt in more creative ways. For instance, while the big grocery chains today run their own distribution systems, Lai’s model shows that outsourcing that function to a third-party logistics firm would reduce emissions without killing off any of the competitors. But companies won’t take that step without the incentive a tax provides.

The Best Policy Option

While this study focuses on retail operations, the lessons it draws apply to other stages of the supply chain as well. And not just transportation but manufacturing or any other activity that generates carbon emissions — for instance, by consuming electricity from coal-fired power plants. The distortions caused by a lack of carbon pricing pervade our economy at all levels.

The researchers also gained some surprising insights into how a carbon tax might be designed. For one thing, while simpler, static models support the conventional wisdom that everyone should pay the full cost of their own emissions, Lai and his colleagues find that an optimal tax would charge companies a higher rate than consumers.

That’s because “companies build their infrastructure before customers enter the picture,” he explains, and those brick-and-mortar decisions are costly to revise. By capturing this time element, the model suggests that policymakers shift the conservation incentive forward to “first movers” in the market. (Stores can still pass the burden back to consumers in higher retail prices.)

Finally, Lai says, a carbon tax would be much simpler to implement than, say, emission limits, which must be tailored to specific production processes. “In our model, in competitive industries, the optimal tax is independent of industry-specific factors.” Whether it’s groceries, chemicals, or construction, if there’s sufficient competition, a single tax rate works across the board.

It’s easy to see why business interests might resist a carbon tax. But arguments that it would harm the economy or that it wouldn’t work under real-world conditions don’t stand up to scrutiny. Quite the opposite, these scholars show: A carbon tax is both more beneficial and easier to administer in competitive markets than in less competitive markets. And the result? More pie for everyone.

 

Supply Chain Design and Carbon Penalty: Monopoly vs. Monopolistic Competition,” by Seung Jae Park, Gérard P. Cachon, Guoming Lai, and Sridhar Seshadri, Production and Operations Management, September 2015.

 

Faculty in this Article

Guoming Lai

Associate Professor McCombs School of Business

Guoming Lai teaches in the Department of Information, Risk, and Operations Management at McCombs. He holds multiple degrees from Tsinghua...

About The Author

Lee Simmons

Lee is a writer and editor at Wired magazine. He studied at Harvard Business School and MIT and taught economics at Harvard College. He was later...

Comments

#1 In the study, how much was

In the study, how much was the impact of all the extra consumer car miles due to having fewer stores in a market?

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