Learning Objective
Provide examples of marginal pricing that influences the use of scarce resources
Why you want to learn this
This summary will help you understand your trash removal, water, gas, and electric bills and see how marginal incentives can help conserve resources
Too much trash
The world is a limited garbage can. If trash disposal has no monetary cost, people will continue to fill up the limited garbage can and there will, eventually, be no more room for trash. Once again, the problem of scarcity and the need for an allocative mechanism rears its ugly head. How can the problem be addressed? In some communities, trash disposal is provided by taxpayers at a zero price to individual households or a flat fee is charged, regardless of the amount of trash collected. It should come as no surprise that people tend to overuse the service. The economist's answer to the problem of overuse of trash disposal is quick and simple: provide a monetary disincentive to using trash disposal services by raising the price of trash disposal from zero to some positive number and do it at the margin. For example, one container of trash disposal costs $4, a second costs $10, and a third costs $25. This marginal monetary disincentive at would reduce the amount of trash generated. Another way to require people to pay directly for the trash they generate would be to sell trash disposal bags that are the only acceptable containers for trash. People who overbuy are free to sell their disposal bags or bins back to the city; those who “underbuy” can always buy more but at a higher price. Neighbors may "rent" their bags to others on those weeks when they have generated less than their usual amount and their neighbors have generated more than the usual.
Unintended consequences of these policies can also occur. For example, because of the higher costs of trash disposal, people might find other ways to dispose of trash. They may dump trash in unintended places (like their neighbors’ yards or remote areas), or they may burn trash, substituting air pollution for ground pollution. On the other hand, there could also be unintended benefits as people turn more of their trash into compost.
Increasing the cost of producing trash is one way to address the problem. A second approach is to decrease the cost of recycling garbage. Some claim that up to ninety percent of all trash can be recycled. Aluminum cans, paper and plastic are obvious examples of materials that can be recycled. The problem is that the cost of recycling is not zero. Individually, people must be willing to use their human capital to get different containers for different types of trash and sort the materials. These costs are disincentives to recycle, although environmentally conscious people may be willing to bear these costs. In addition, people may be willing to collect trash for recycling if they can sell it to recycling businesses, but for many people these incentives will be insufficient. If policymakers wish to encourage recycling they may need to provide other incentives.
Incentives that lower the cost of recycling or increase the benefits will increase the percentage of trash that is recycled. Trash collectors might pick up separated recyclable materials in containers provided by the local government, crediting the account of those who participate in the recycling effort. Addresses can be stamped on the containers to avoid theft. It must be remembered, however, that none of this is costless. In addition to the resources used to increase the percentage of trash that is recycled, the vehicles used to collect the recyclables add to the level of pollution. A rational policy will motivate recycling as long as the marginal benefit is greater than the marginal opportunity cost. If we go beyond that we are giving up some education or public safety or health care or consumption of other goods and services that are valued more highly than the benefits of recycling.
Bottom line: Market incentives can be used to influence the use of scarce resources. Marginal pricing can be an effective method to encourage conservation of resources. There can, however, be unintended consequences.
Water
If there is a drought, there are plenty of ways to provide incentives to reduce water consumption. Water is a scarce resource and the market price of water, if determined by market forces, will reflect its relative scarcity. Many water consumers get their water at below market price. In some cases, the price that consumers pay doesn’t cover the costs of delivering water. Price has been proven to be an effective disincentive. If you want people to consume less water, raise the price and/or charge at the margin.
Although households are relatively small water consumers, the incentive structure in many areas is perverse in the sense that it is inconsistent with conservation efforts. A flat fee for water usage is less effective in rationing the scarce resource than would be a marginal approach with a metered billing system, using an increasing scale charging less for the first level of water use, more for the second level, etc. A marginal billing system provides incentives for more efficient water use. Increased prices provide incentives to install water-saving showerheads, toilets, and home irrigation systems if the devices and their installation are less costly than the water.
Drip irrigation systems could dramatically reduce the amount of water used, particularly by farmers. However, as long as benefit/cost analysis suggests that, at the subsidized water rates, wasteful irrigation systems are less costly for the farmer than drip systems, agriculturalists will continue to overuse the resource. As long as the incentive structure encourages inefficient irrigation systems, water supply will continue to be a problem. If farmers are using what is considered to be too much water, an efficient and, in this case effective method of decreasing the amount of water used is to increase the monetary disincentive to do so, the price of water, at the margin. The same can be applied to households, although it is important to remember that they are relatively small consumers of water compared to farmers. Nevertheless, it is predictable that progress could be made in terms of water conservation by employing a marginal billing system.
Bottom Line
Many issues can be addressed by using market incentives, particularly at the margin. It’s important, however, to attempt to predict what would otherwise be unintended consequences. If higher market prices are used, what distributive effects occur? If the poor are priced out of the market, is there political will and an efficient way to address the problem? Do the marginal benefits of the pricing policy outweigh the marginal opportunity cost?