FEDERAL RESERVE BANK OF DALLAS
FOURTH QUARTER 1998
How Increased Product Market
Competition May Be Reshaping
AmericaÕs Labor Markets
John V. Duca
Privatization and the
Transition to a Market Economy
Jason L. Saving
Global Warming Policy:
Some Economic Implications
Stephen P. A. Brown
Economic Review
Federal Reserve Bank of Dallas
Robert D. McTeer, Jr.
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Senior Economists and
Assistant Vice Presidents
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John V. Duca
Robert W. Gilmer
Evan F. Koenig
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Economics, and Assistant Vice President
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Senior Economist and
Research Officer
Mine K. YŸcel
Economists
Robert Formaini
David M. Gould
Joseph H. Haslag
Keith R. Phillips
Stephen D. Prowse
Marci Rossell
Jason L. Saving
Fiona D. Sigalla
Lori L. Taylor
Lucinda Vargas
Alan D. Viard
Mark A. Wynne
Carlos E. J. M. Zarazaga
Research Associates
Professor Nathan S. Balke
Southern Methodist University
Professor Thomas B. Fomby
Southern Methodist University
Professor Gregory W. Huffman
Southern Methodist University
Professor Finn E. Kydland
Carnegie Mellon University
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University of Houston
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Contents
How Increased
Product Market
Competition May Be
Reshaping AmericaÕs
Labor Markets
John V. Duca
Page 2
Privatization and the
Transition to a
Market Economy
Jason L. Saving
Page 17
Global Warming Policy:
Some Economic
Implications
Stephen P. A. Brown
Page 26
In this article, John Duca discusses how and why compensation has become more market sensitive in the United States.
Specifically, he illustrates how fiercer product market competition
can theoretically reduce the prevalence of nominal wage contracts
and of indexation in such contracts, while boosting the use of profit
sharing. He also summarizes empirical findings supporting the view
that increased competition has reduced the use of nominal contracts and the indexation of contract wages, and presents limited,
inconclusive data supporting the view that greater product market
competition has boosted the overall use of profit sharing. Consistent with aggregate movements in labor practices and a measure of
the degree of goods market competition, industry-level data are
presented that indicate these changes in labor practices are most
evident in sectors that have experienced either deregulation or
increased foreign competition since the late 1970s. While more
research needs to be done, particularly using industry-level data,
new theoretical arguments and empirical evidence support, but do
not conclusively prove, the view that increased product market
competition has been reshaping AmericaÕs labor markets.
The Chinese government has announced its intention to privatize thousands of state-owned enterprises. Such an effort would
dwarf recent privatizations in the industrialized West and be comparable only to the Eastern European experience following the fall
of the Soviet Union. As such, an examination of the Eastern
European privatization may provide valuable lessons for China and
any other developing economy that embarks upon a large-scale privatization program.
In this article, Jason Saving considers three problems with
which Eastern European privatizations have had to contend: a
scarcity of information, an inability to exercise managerial oversight, and the absence of competitive markets. He suggests that a
lack of information need not prevent privatization. He explores
the holding company as a potential solution to the managerial-
oversight problem. And he suggests that effective privatization
requires both managerial oversight and a legal framework that permits freedom of entry for competing firms.
Many analysts believe that the emissions of greenhouse gases
resulting from human activity are contributing to global warming,
but the linkage is highly uncertain. The largest such source of these
gases is carbon dioxide (CO2) from the growing consumption of
fossil fuels. Consequently, the conservation of fossil fuels figures
prominently in any strategy to reduce the threat of global warming.
Because there is considerable uncertainty about the benefits
of reducing CO2 emissions but the costs of conservation can be
readily quantified, some analysts have suggested that reducing the
emissions is like insurance. In this article, Stephen Brown integrates
a growing literature on the damage caused by global warming with
a world energy model to do a costÐbenefit analysis of U.S. compliance with the accord adopted at the United Nations conference on
global warming held in late 1997. His analysis shows that reducing
U.S. emissions to comply with the accord would represent too
much insurance against global warming.
How Increased
Product Market
Competition May
Be Reshaping
AmericaÕs Labor
Markets
John V. Duca
Senior Economist and Assistant Vice President
Federal Reserve Bank of Dallas
New theoretical arguments
and empirical evidence
supportÑbut do not
conclusively proveÑthe view
that increased product market
competition has been reshaping
AmericaÕs labor markets.
In recent years, inflation has drifted lower
as the unemployment rate has fallen below
trigger levels that have been associated with
rising inflation. Indeed, since mid-1996 the
unemployment rate has been 5 percent or
lowerÑwell below the 5.5 percent to 6 percent
trigger-point estimates of many economistsÑ
while core inflation has remained low.1 Although wage inflation has drifted higher and
worker shortages abound, there is less upward
wage pressure than prior experience would
suggest.
These developments have spurred a reexamination of the view that there is a trigger level
of unemployment, below which inflation tends
to rise and above which inflation tends to fall
(see Phelps 1967; Friedman 1968). This trigger
level is called the nonaccelerating inflation
rate of unemployment (NAIRU). Some critics
argue that the concept should be abandoned
(Galbraith 1997), while others argue that the
NAIRU is so imprecisely estimated it has
limited use as a policy guide (Staiger, Stock, and
Watson 1997). However, these critics do not
shed light on why the relationship between
unemployment and changes in inflation has
apparently shifted. Others maintain that the
NAIRU needs to be modified for factors such as
changing demographics (see Gordon 1997),
sociological changes (Blanchard and Katz 1997),
or the impact of unemployment spells on worker
skills (also known as hysteresis effects; see
Blanchard and Katz 1997). The weaknesses of
these conclusions are that demographic adjustments to the unemployment rate cannot explain
the behavior of the 1990s, sociological factors
are difficult to track, and the evidence on hysteresis effects for the United States is weak.
Another shortcoming of these arguments
for modifying the NAIRU is that they are inconsistent with both the U.S. economyÕs performance in the 1990s and the perceptions of firms
and workers about why the relationship between inflation and unemployment may have
changed. For example, while inflation, GDP
growth, and unemployment imply that the U.S.
economy has performed well at a macroeconomic level in the mid-1990s, there has been an
increased sense of job insecurity at the firm
or industry level, after adjusting for different
phases of the business cycle.
An alternative explanation for the combination of these macro- and microlevel developments is that we are in a new era in which
technological innovation and global trade are
curtailing inflation. Under this new paradigm,
two sources of low inflation are (1) cheaper
2
imports from higher worldwide capacity and (2)
innovations that boost productivity.
The jury is still out on these two sources.
First, although import prices have fallen, much
of the drop is a result of a stronger dollar and
declining oil prices. Consequently, it is difficult
to decipher any impact of global capacity.
Second, it is not yet clear that long-run productivity growth has risen above its post-1972 average. Even if statistics understate growth in
productivity, an upward shift in productivity
growth does not necessarily mean that the
NAIRU is lower. Faster productivity growth may
initially offset increasing wage growth resulting
from low rates of unemployment. However, the
NAIRU hypothesis implies that keeping unemployment at current levels will spur continued
increases in wage growth that eventually will
more than offset the higher level of productivity
growth and will boost inflation.2
Another explanation for the combination
of low unemployment and low inflation is
that fiercer product market competition has
restrained firms from hiking prices and wages
and is inducing firms to change the ways they
employ and pay workers. This explanation is
sometimes associated with Ònew paradigmÓ
arguments, but it is not based on faster productivity growth (Duca 1998). The ÒcompetitionÓ
explanation is consistent with reports from
Federal Reserve Beige Book respondents (see
the box entitled ÒFederal Reserve Beige Book
Reports of Competition and InflationÓ). This
article reviews how and why increased product
market competition may be reshaping AmericaÕs
labor markets.
The analysis focuses on three important
trends in U.S. labor markets. The first is the
Figure 1
Unions on the Decline
Percent of private payrolls
Õ96Õ91Õ86Õ81Õ76Õ71Õ66Õ61Õ56
SOURCES: Troy and Sheflin (1985); Bureau of Labor Statistics;
Duca and VanHoose (1998b).
40
35
30
25
20
15
10
Federal Reserve Beige Book Reports
of Competition and Inflation
Several Federal Reserve Beige Book reports are consistent with the view that
heightened competition has curtailed inflation in recent years. While the anecdotal
reports are suggestive and are not sufficient evidence alone, they are consistent with
the view that the degree of competition is higher now than in previous expansions.
With this in mind, consider the following noteworthy excerpts from recent Beige
Books covering the mid-1990s:
Manufacturers note that competitive pressures are restraining prices for
most products. (April 1994, iii)
Most Districts report that competitive pressures continue to temper price
increases on the output side. (June 1994, iv)
Price increases are noted among a broad range of business materials....
However, virtually all Districts report that competitive pressures are holding
prices down at the retail level.... (July 1994, iiÐiii)
Industrial materials prices edged up further, but businesses say that competitive pressures continue to restrain price increases on finished goods.
(September 1994, i)
Chicago, Kansas City, and Dallas report that intense competition among
retailers kept prices flat despite increased input costs. (March 1995, v)
Contacts in the temporary services industry said despite wage pressures
they could not raise fees because of fierce competition. (November 1995, v)
Competition continues to drive down retail prices in mall stores. (Boston
District, November 1995, I-1)
Several districts attribute the modest size of upward price movements to
competitive conditions. (March 1996, iii)
declining use of medium-term nominal wage
contracts. This trend is evidenced by the falling
share of private workers represented by unions,
which negotiate labor contracts that typically
set future nominal wages (Figure 1 ).3 Another
important trend has been a decline in the share
of union contracts that index or adjust wages for
inflation according to a preset formula. As
Figure 2 indicates, inflation risk, as tracked by
the percent change in the U.S. Consumer Price
Index (CPI), is positively correlated with the use
of indexation. The drop in inflation since the
early 1980s likely explains much of the decline
in indexationÑespecially in the 1980s (Holland
1995). However, inflation is not the only factor
behind this decline because inflation in the
early 1990s was at levels near those of the
1950s, while indexation was twice as prevalent
in the earlier period. Duca and VanHoose
(forthcoming b) provide theoretical arguments
and evidence that this difference may reflect a
greater degree of product market competition.
The third significant trend has been the rise of
profit sharing (Duca and VanHoose, forthcoming a), as shown in Figure 3, which plots the
incidence of profit sharing in pension plans (Bell
FEDERAL RESERVE BANK OF DALLAS 3 ECONOMIC REVIEW FOURTH QUARTER 1998
Figure 2
Fewer Union Contracts Are Indexed for
Inflation Than in the 1950s
Percent Percent of union contracts
16
Inflation
Indexation
80
14
70
12
60
10
8
50
6
40
4
30
2
0
20
Õ56 Õ61 Õ66 Õ71 Õ76 Õ81 Õ86 Õ91 Õ95
SOURCE: Bureau of Labor Statistics.
and Kruse 1995). Together, these trends can be
viewed as making work and pay more sensitive
to market conditions (Duca 1998).
I begin with a discussion of the theoretical
intuition for how changes in the degree of product market competition may have spurred these
changes in labor practices. I then review and
interpret empirical evidence on these theoretical
implications.
THEORETICAL LINKS BETWEEN LABOR PRACTICES
AND THE DEGREE OF MARKET COMPETITION
To analyze how goods market competition
may affect labor practices, this article draws on
several papers by Duca and VanHoose (1991,
1998a, forthcoming a, and forthcoming b), who
combine the multisector frameworks of Blinder
and Mankiw (1984) and Duca (1987) with the
monopolistic competition framework of Ball
(1988). The multisector approach permits the
analysis of sectoral as well as aggregate shocks
and allows for heterogeneity in labor practices.
Thus, it is flexible enough to analyze how different susceptibility to sectoral shocks may
affect pay practices and why some sectors may
adopt nominal wage contracts or index such
contracts for inflation while others do not.
Incorporating BallÕs monopolistic competition
framework permits the analysis of how labor
practices are affected by changes in the overall
price elasticity of demand. The greater this elasticity, the greater the extent to which firms
compete in product markets. Thus, by combining aspects of multisector and monopolistic
competition frameworks, it is possible to analyze how changes in the degree of product
market competition can affect labor practices in
a world where firms face aggregate and industry-
specific shocks.
Rather than rederiving the results of other
papers, the section below describes the basic
theoretical framework common to these studies
and then reviews the intuition behind key findings on contracts, indexation, and profit sharing,
using charts or simple equations.
Basic Theoretical Framework
The economy contains a continuum of
sectors, indexed by j, that are distributed uniformly between one and zero, which allows for
aggregation of sector outputs. Each sector contains a large number of representative firms and
workers, and relationships are expressed in logs
(lowercase letters) with constants suppressed.
A representative firm in sector j produces output (y) with employment (l ) according to
(1) yj = a lj + q ,
where 0 < a < l, and q is an aggregate supply
shock raising output per hour in all sectors.
Following Ball, assume that the demand
for a firmÕs output in sector j (yj ) as a share of
total output (y) depends on relative prices
according to the log-linear equation
(2) yj Ð y = Ðe(pj Ð p) + d j ,
where ¥ is the absolute size of the price elasticity of demand, the aggregate price level
(P) = (˜Pj
(1Ðe)dj )1/(1Ðe), the log of the price level (p)
= ˜pjdj , and d j reflects sector-specific (independently and identically distributed) demand shocks
that sum to zero.
Figure 3
The Rise of Profit Sharing and
Goods Market Competition
Percent of workers with pension plans Index
22
Profit sharing
Competition
8.3
20
8.1
18
7.9
16
7.7
14
7.5
12
7.3
10
7.1
8
6.9
6
6.7
Õ80 Õ81 Õ82 Õ83 Õ84 Õ85 Õ86 Õ87 Õ88 Õ89 Õ90 Õ91 Õ92 Õ93
SOURCES: Bell and Kruse (1995); authorÕs calculations.
4
For simplicity, aggregate demand accords
with the quantity theory of money
(3) y = m + v Ð p,
where m is the log of the money stock and v is
a velocity shock common to all sectors. The
shock to aggregate demand shock is (m + v),
but for simplicity, money shocks are zeroed out
to reduce notation and avoid adding complications associated with different monetary policy
rules. For simplicity, each of the aggregate
shock variables (q and v) has an expected value
equaling zero in logs, is independently and
identically distributed, and has a fixed variance
(s 2
q for q and s 2
v for v).
Sectors differ in how much sectoral
demand shock variance they face, which is
assumed to equal sd
2(1 Ð j )/j. Because the index
number j is distributed normally between zero
and one, the sectoral demand shock variances
range from infinity for sector j = 0 to zero for
sector j = 1.
Converting Equations 1 through 3 into levels, combining the resulting terms into an
expression for profits (p j = PjYj Ð WjLj ), and differentiating implies labor demand is
d
(4) lj = [Ðe(wj Ð pj) + (v + d j Ð pj)
+ (¥ Ð 1)q ]/[a + ¥ Ð a e].
The first term in the numerator reflects that
labor demand is declining in the nominal wage
but increasing in terms of the sector-specific
price. The second term reflects that labor
demand rises to the extent that aggregate
demand shocks boost overall prices relative to
the sector j price or that sectoral demand
shocks raise the relative demand for sector j Õs
output. The last term in the numerator implies
that a supply shock that raises productivity will
boost labor demand. To make the model solvable, assume that labor is immobile across sectors in the short run owing to specialization and
that labor supply is
ss
(5) lj = c (wj Ð p),
where c is a parameter > 0, reflecting that labor
supply depends on the real purchasing power
of wages. Equations 4 and 5 yield a reduced-
form solution for the market-clearing wage,
which reflects a balance between labor supply
and labor demand, where the former depends
on the real wage and the latter depends on the
marginal revenue product of labor (MRPL) in
that industry. As goods markets become more
competitive, ¥ is higher and labor demand
becomes more sensitive to the MRPL. Consequently, the market-clearing wage in an indus
try depends more on supply shocks and sectoral demand shocks affecting the MRPL and
less on the real purchasing power of wages (see
Duca and VanHoose 1991).
Illustrative Arguments
A firmÕs labor demand depends on the
change in total revenue due to a small change
in labor hired. Under perfect competition, labor
demand equals the price times the marginal
physical product of labor (MPPL). The MPPL is
related to the marginal cost of producing output
(MC), shown in the left panels of Figure 4. Since
the MPPL tends to fall as more labor is used,
holding other factors constant, the competitive
demand for labor (LDj ) is downward sloping
(upper right panel of Figure 4). Holding aggregate prices and price expectations constant, the
labor-supply curve is upward sloping and shifts
in line with changes in aggregate prices or price
expectations. Since wages and employment reflect
both labor supply and demand, the competitive
outcome is given by point A. Under wage contracts, firms employ as much labor as they desire at a constant nominal wage that equals the
prior time periodÕs expectation (t Ð 1) of conditions at time t: Et Ð1(wt ). Thus, contracts replace
the spot labor-supply curve with a horizontal
wage-contract curve, which only shifts in period
t if a contract is indexed for inflation or profits.
Under imperfect competition (lower panels), labor demand reflects the MRPL, which
equals the marginal revenue of one more unit of
output (MR) times the MPPL. Since boosting
output lowers prices for an imperfectly competitive firm, marginal revenue is always below
price. Thus, such firms produce at an output
level below the perfect competition solution
such that marginal revenue equals marginal cost
(point S; superscript SP denotes spot market
variable solutions).
Nominal Wage Contracting
To analyze the extent of nominal wage
contracting, assume that a share (W ) of firms set
contracts in period t Ð 1 that cover period t and
set the nominal wage equal to the t Ð 1 expectation of the next periodÕs market-clearing wage.
The remaining share (1 Ð W ) of firms pays spot
market wages. For now, assume that contracts
are not indexed for inflation and there is no
profit sharing. In addition, assume that workers
choose between spot and contract wages to
minimize a weighted average of the expected
squared deviations of employment and the real
wage from their market-clearing levels. While
other loss functions are plausible, this assump-
FEDERAL RESERVE BANK OF DALLAS 5 ECONOMIC REVIEW FOURTH QUARTER 1998
Figure 4
Labor Markets Under Perfect and Imperfect Competition
Product Market Labor Market
Perfect Competition
Pj
Wj
A
MC
A
LjS
WjC= E(W), WjA WjC
PjA
D
(industrywide)
LjD= Pj « MPPLj
YjA
Yj LjA
Lj
Imperfect Competition
S
A
S
Yj Lj
tion yields solutions that permit one to infer the in the face of supply and sectoral demand
qualitative impact of altering either the degree shocks but raise the variance of employment.
of market competition or the variances of the Thus, trade-offs emerge, and the extent of con-
different shocks under reasonable parameter tracting depends on how workers weigh real-
assumptions. wage versus employment stability.4 This model
Solutions reveal that relative to spot yields an interior solution such that there is a
wages, wage contracts raise the exposure of real critical sector that is indifferent between using
wages to aggregate demand shocks but reduce contract or spot wages, with workers more
the exposure to sectoral demand shocks. likely to opt for contracts in industries facing
Contracts also lower the variance of real wages above-average sectoral demand variance. This
Pj
Pj
SP
D
MR
MC
Wj
Wj
C
Lj
S
Wj
C SP = E(Wj), Wj
SP SPYj Lj
Lj
D = MRj « MPPLj
6
result arises for two reasons. First, for each sector, wage contracts introduce the same degree
of employment and real-wage instability in the
face of aggregate shocks. Second, since sectors
face differing degrees of sectoral demand variance, contracts pose more real-wage stability
relative to higher employment variance for
workers in sectors with high sectoral variance.
By assumption, the range of sectoral variance is so wide that workers in sector j = 0 face
an infinite sectoral variance and will always
choose to use contracts because the sectoral
variance dwarfs the variances of aggregate
shocks, whereas those in sector j = 1 face zero
sectoral variance and will never use contracts.
While these are theoretical extremes, the qualitative implications accord with the higher
unionization rates in more cyclical industries.
For some intermediate value of j, the sectoral
and aggregate shock variances balance out,
implying that there is some sector that is indifferent between nominal wage contracts and
spot wages. This balance depends on the degree of product market competition. As the
price elasticity of demand rises, the cost of
potential job losses induced by nominal wage
contracts rises relative to the benefits of real-
wage stability, thus reducing the net benefits of
wage contracts and causing some sectors to shift
from wage contracts to spot wages.
To analyze how the degree of competition
affects the extent of nominal wage contracts,
suppose that the price elasticity of demand
rises. On the one hand, this reduces the responsiveness of each firmÕs price to a given-size
demand shock, implying that such shocks have
smaller effects on the marginal revenue product
(and labor demand) and on spot wages as product demand becomes more price sensitive. At
the same time, the greater demand elasticity
implies that labor demand falls more in response
to a given gap between contract wages and lower
spot wages. As a result, greater goods market
competition lowers the net benefit of nominal
wage contracts in the face of sectoral demand
shocks by reducing the volatility in spot real
wages relative to the volatility of employment
under nominal wage contracts. On the other hand,
in the face of aggregate demand shocks, greater
competition implies that wage contracts pose
somewhat lower downside costs in terms of real
wage and employment volatility. However,
greater competition clearly boosts the degree
to which labor demand responds to aggregate
supply shocks and thereby the extent to which
contracts boost the volatility of employmentÑa
key downside cost of contracts.
To demonstrate these results, focus on the
case in the upper panels of Figure 5, where the
economy starts in a zero shock equilibrium
(point O) and the price elasticity of demand is
low. Suppose an unanticipated sectoral demand
shock puts downward pressure on the price of
industry j Õs product but has no effect on overall
prices. Since aggregate prices and price expectations are unaffected, the labor-supply curve is
unaffected. However, the drop in the relative
demand for industry j Õs product shifts the demand and marginal revenue curves for industry
j left (shift 1). Since profit-maximizing firms produce at levels where marginal cost equals marginal revenue, output falls in the upper left
panel from Y Oj (point O) to Y SP if contracts are
j
not used. In labor markets, market-clearing or
spot wages and employment fall from W Oj and
LO (point O) to W SP and L SP (point S ), respec
j jj
tively. However, if wage contracts are used,
employment falls further to LCj (point C ), where
the marginal cost of labor equals its marginal
revenue product, and output falls further to Y Cj .
Thus, nominal wage contracts protect real
wages from sectoral demand shocks but at the
cost of increased volatility of employment.
Now consider what happens under a high
price elasticity of demand, where the MRPL
(marginal revenue times MPPL) curve is flatter
and prices fall less. The MRPL curve in the
lower right panel shifts by less than in the upper
right panel. Despite the flatter slope of the
MRPL curve in the lower panel, it can be shown
that wages and employment fall by slightly less
than in the upper panel under each wage practice. Nevertheless, when relative demand shocks
occur, the flatter MRPL curve implies that less
real-wage stability is gained relative to extra
employment instability induced by using wage
contracts.
Now consider an aggregate demand shock
(left panels of Figure 6), where the analysis differs in that the labor-supply function shifts out
to the extent that a negative aggregate demand
shock lowers aggregate prices. For this reason,
the labor supply curve shifts right, leaving spot
employment unchanged at LOj , spot nominal
wages lower at W SP
j , and spot real wages (W/P,
not shown) unchanged. Since contracts prevent
a decline in wages relative to sectoral demand
shocks, aggregate demand shocks induce bigger
employment and real-wage deviations from
spot market and initial values under wage contracts. However, wage contracts pose less real-
wage volatility in the face of aggregate demand
shocks because such shocks affect prices less
under tougher market competition.
FEDERAL RESERVE BANK OF DALLAS 7 ECONOMIC REVIEW FOURTH QUARTER 1998
Figure 5
Negative Sectoral Demand Shock and Nominal Wage Contracts
Product Market Labor Market
Low Price Elasticity of Demand
Pj
D¢
S
O
MRO
1
1
Wj
SOC
1
LjS(P)
PjO MC
PjC
PjSP
^
WC
WjSP
WjO = E(Wj)
MRPLOj = MRjO « MPPLOj
DO
MRPLj ¢ = MRj¢« MPPLjO
SPYjO SP LOj
Lj
YjCYj
Yj LCj Lj
High Price Elasticity of Demand
Pj
Wj
SOC
1
LjS(P)
Dj ¢
S
OC
MRO
MR¢
Dj
O
1
1
MC
PjO
^
WC
MRPLj
WjO = E(Wj)
C
Pj
PjSP
YjCYjSPYjO Yj
In contrast, the downside costs of wage
contracts stemming from aggregate supply
shocks are much greater when product markets
are more competitive. Consider a negative
aggregate supply shock that shifts the MRPL
curves of every industry inward by a given distance (right panels of Figure 6, shift 1). In addition, the aggregate supply shock causes an
overall rise in prices, which induces an upward
shift (shift 2) in the spot labor supply curve
equal to the aggregate rise in prices. Spot wages
and employment fall from W Oj and LOj (point O)
to W SP and LSP (point S), respectively, while con
jj
tract employment falls further to LCj (point C ).
Comparing the upper and lower right panels,
WjSP
OO
= MRjO « MPPLj
MRPLj ¢ = MRj¢« MPPLjO
Lj
SPLOj
LCj Lj
the extent to which nominal contracts exacerbate employment losses when supply shocks
occur is much higher when competition is more
intense. Fundamentally, the fiercer the competition, the more falling spot wages cushion the
drop in output. Thus, the downside of using
contracts when supply shocks occur increases
as the price elasticity increases.
In summary, on the one hand, greater
competition slightly lowers the downside risk of
using contracts in the face of aggregate demand
shocks. On the other hand, it also cuts the net
benefit of contracts when sectoral demand
shocks occur and clearly raises the disincentive
to contract because of supply shocks. If sectoral
8
Figure 6
Negative Aggregate Shocks and Nominal Wage Contracts
Aggregate Demand Shock Aggregate Supply Shock
Low Degree of Competition
Wj
SO
1
S(PO)
S(PSP)
2MRjLj
Wj
S
OC1
LSj (PSP)
S(PO)Lj
Lj
WjC
C
WjO=E(W^
j) WjC WjO=E(W^
j)
WjSP
MRPLOj =
O « MPPLjO
MRPLOj =
MRjO « MPPLjO
WjSP
MRPLj ¢ = MRjO « MPPLj ¢
MRPLj ¢ = MRj¢« MPPLjO
Lj
Lj
LjC LjO = LjSP LjC LjSP LjO
High Degree of Competition
Wj
WjO =E(W^
j)
WjSP
LjC LjO = LjSP
demand and aggregate supply shocks are large
enough relative to aggregate demand shocks,
then use of nominal wage contracts will
arguably fall as the degree of product market
competition rises.
Wage Indexation
Thus far I have assumed that workers and
firms choose only between spot wages or wages
that are set ahead of market conditions. In practice
some contracts include clauses that adjust wages
for inflation or profits, according to a previously
arranged formula. For now, consider whether a
firm indexes nominal wages for inflation.
Wj
Lj
Wj
C Wj
C
S
O
C
MRPLj ¢ = MRj¢ « MPPLj
O
S
OC
1
2
Lj
S(PO)
Lj
S (PSP)
Lj
S(PO)
Lj
S (PSP)
Wj
SP
1
2
MRPLj ¢ = MRj
O « MPPLj ¢
^ Wj
O =E(Wj)
MRPLj
O =
MRj
O « MPPLj
O
MRPLj
O =
MRj
O « MPPLj
O
Lj
CSP O
LjLj Lj
Indexation protects real contract wages
from aggregate demand variations by keeping
contract wages close to their market-clearing
level, which moves with inflation. The intuition
behind this result is that an expansionary aggregate demand shock will push up inflation and
the spot nominal wage. Hence, indexation helps
limit deviations of contract wages from market-
clearing wages when aggregate demand shocks
occur. However, as Gray (1976) shows, indexation moves contract wages further from their
full information level when aggregate supply
shocks happen. Intuitively, a negative aggregate
supply shock boosts inflation and lowers the
FEDERAL RESERVE BANK OF DALLAS 9 ECONOMIC REVIEW FOURTH QUARTER 1998
real marginal product of labor. In such cases,
the spot real wage would fall, whereas cost-ofliving escalator clauses would prevent a decline
in the real contract wage toward its new spot
market level. As a result, the presence of aggregate supply shocks makes incomplete indexation optimal, and a trade-off emerges in which
indexation is more attractive the greater the ex
ante variance of aggregate demand shocks relative to the ex ante variance of aggregate supply
shocks.
For plausible variation in aggregate
demand and supply shocks, this trade-off
implies that a sector exists that is indifferent
between indexing and not indexing. Suppose
the degree of product market competition rises.
Then each firmÕs price and marginal product
of labor curve become less sensitive to aggregate demand variations. Thus, employment at
contract firms is also less sensitive to demand
shocks, reducing the incentive to index. Increased competition also means that aggregate
supply shocks pose greater downside costs in
the form of employment losses from indexing
wages.
In analyzing the impact of the degree of
competition on indexation choices, it is relevant
to consider aggregate rather than sectoral
shocks because, by definition, only aggregate
shocks affect the overall price level. For ease of
exposition, comparisons are made between
nonindexed wage contracts and contracts fully
indexed for inflation.
First, consider a negative aggregate demand shock that shifts the MRPL curve leftward
(left panels of Figure 7, shift 1). The flatter slope
of the marginal revenue curves in the high price
elasticity case (lower panel) implies a smaller
shift of the MRPL curve. Because indexation
shifts the wage-contract curve (W Cj ) down (shift
3) in line with the shifts in the MRPL curves and
spot labor-supply curve (shift 2), work hours
and real wages are unaffected whether the price
elasticity is high or low (depicted by point I ).
However, if contract wages are not indexed, these inward shifts imply a decline in
employment and a rise in real wages (depicted
by point C in both left-hand panels) because the
wage contract curve does not move. The extent
to which either employment or real wages are
affected by not indexing can thus be seen as
proportional to the benefit of indexing. Suppose
the price elasticity of demand is relatively low,
as in the upper left panel. If contract wages are
not indexed, then employment falls by the gap
between LOj and LCj in the upper left panel
and real wages rise by the gap between W Cj and
W SP
j since prices fall by that magnitude. But
when demand is more elastic (lower left panel),
the drop in contract employment and the
change in the real contract wage are smaller.
This occurs because the MRPL curve shifts less
in response to aggregate demand shocks when
demand is more elastic. Thus, the fiercer the
degree of goods market competition, the lower
the incentive is to index in the face of aggregate
demand shocks because indexing poses smaller
benefits.
To analyze the downside cost of indexing
when aggregate supply shocks occur, consider
a common supply disturbance that shifts the
MRPL curves downward, shown in the right
panels of Figure 7 (shift 1). Under indexation,
the higher price level would shift the wage
curves in these panels upward (shift 3) so that
the nominal wage would rise as much as the
overall price level, leaving the real wage
unchanged if employment remained at LOj .
However, because labor demand has shifted left
(shift 1), the nominal spot wage (W SP at point S )
j
is below the level that maintains a constant real
wage (W jI at point I ). If contracts are not
indexed, the labor-supply curve does not shift
and employment falls to Lcj (point C ). However,
if contract wages were indexed for inflation, the
wage-contract curve (right panels) would shift
up so that the real wage would be unchanged
(point I ), inducing a rise in wages to W jI and a
bigger fall in employment to LjI . While aggregate
supply shocks cause employment under wage
contracts to deviate from its market-clearing
level in both cases, the deviation is larger under
indexation. In addition, the greater the degree
of market competition, the flatter the MRPL
curve is (lower left panel) and the more indexation pushes employment and wages from their
full information levels (point S ).
Since increased employment variation in
the face of aggregate supply shocks is the major
downside cost of indexing and less employment/real-wage variation in the face of aggregate demand shocks is the major benefit, there
is less incentive to index when the degree of
product competition is greater. As a result, the
prevalence of indexation clauses in nominal
wage contracts should fall as the degree of
product market competition rises.
Profit Sharing
To analyze how increased product market
competition affects the incidence of profit
sharing in labor contracts, assume that the share
of the labor force covered by contracts is constant, as in Duca and VanHoose (forthcoming
10
Figure 7
Negative Aggregate Shocks and Wage Indexation
Aggregate Demand Shock Aggregate Supply Shock
Low Price Elasticity of Demand
Wj
Wj
S,I
O
S(P¢)
S(PO)Lj
1 Lj
S
O
C
I
1
3 3
2
MRPLj ¢ = MRj
MRPLj
O
Lj
SMRj
O « MPPLj
Lj
S(P¢)
(PO)
2
WjI WjI
^ WjC Wj,E(Wj)
WjC
C
WjSP
E(Wj)
3
WjSP = WjI
WjI
=
OMRPLOj = MRjO « MPPLjO
MRPLj ¢ = MRj¢« MPPLjO
O « MPPLj ¢
Lj
Lj
LjC LjO = LjSP = LjI LjI LCj LjSP LjO
High Price Elasticity of Demand
Wj
S(PO)
Lj
12
O
^
E(Wj)
S,I
WjSP = WjI
LCj LjO = LjSP = LjI
b). As is standard in much of the wage indexation literature (Gray 1976; Karni 1983), assume
also that the optimal contract minimizes deviations from the market-clearing wage and employment levels.
Under these conditions, the optimal wage
contract adjusts the contract wage to mimic the
spot wage, which equates labor supply with
labor demand. The market-clearing wage reflects that labor demand depends on the marginal product of labor in that industry and labor
supply depends on the real wage in terms of the
overall price level. A higher degree of product
market competition makes labor demand more
Wj
Lj
Wj
I Wj
I
Wj
C Wj
^ W C = E(Wj)
C
S
OC
I
3
3 3
1 2
MRPLj
O =
MRPLj ¢ =
Wj
I
MRj
O « MPPLj
O
MRj¢ « MPPLj
O MRPLj ¢ =
MRj
O « MPPLj ¢
Wj
SP
MRPLj
O
MRj
O « MPPLj
O
Lj
S(P¢)
Lj
S(PO)
S(P¢)
Lj
C
=
Lj
I CSP O
Lj LjLj Lj
elastic, as represented by a larger magnitude of
¥ in Equation 4. As a result, equilibrium wages
and employment at firms with contracts become
more sensitive to changes in the MRPL that arise
from sectoral demand shifts. For this reason, the
relative degree to which spot market wages
reflect overall prices, rather than the sectoral
marginal product of labor, is higher the greater
the sensitivity of labor supply to the real wage
and the greater the significance of labor in production. By contrast, profit sharing becomes
more important and inflation indexation less
appropriate as the extent of goods market competition rises, which makes labor demand more
FEDERAL RESERVE BANK OF DALLAS 11 ECONOMIC REVIEW FOURTH QUARTER 1998
sensitive to the MRPL. Although the market-
clearing solution for sectoral wages is complicated, as markets become perfectly competitive
(e¨´ ), the equilibrium wage implied by Equations 4 and 5 approaches
(6) wj = g (pj + q ) + (1 Ð g )p,
where (pj + q ) can be interpreted as the sector-
specific price adjusted for positive supply shocks,
g = 1/[c (1 Ð a ) + 1] < 1 is the weight on the
MRPL in determining wages,5 and (1 Ð g ) is the
relative importance of overall prices for spot
wages.
In practice, one does not observe the
explicit indexation or adjustment of wages to
the MRPL in a particular industry, mainly
because it is difficult to measure and verify this
variable. However, as the degree of product
market competition rises, the MRPL moves more
in tandem with firm profits, a result formally
shown by Duca and VanHoose (forthcoming b).
Basically, greater competition reduces the
extent to which firms boost prices rather than
output when the relative demand for that sectorÕs product rises. As a result, wages and profits more closely reflect the MRPL. For these
reasons, greater market competition boosts both
the incentive to index wages to the MRPL and
the desirability of using profit sharing as a
means of doing so.
EMPIRICAL EVIDENCE ON PRODUCT MARKET
COMPETITION AND LABOR PRACTICES
Although increased product market competition can theoretically affect labor practices,
there has been little empirical macro work on
Figure 8
Unionization Rates by Industry Groups
Percent of private payrolls
Manufacturing
Other private industries
Deregulated industries
Õ96Õ95Õ94Õ93Õ92Õ91Õ90Õ89Õ88Õ87Õ86Õ85Õ84Õ83
SOURCE: Bureau of Labor Statistics.
35
30
25
20
15
10
5
this issue. The few related studies done before
the late 1990s were largely microeconomic studies that compared cross-sectional patterns of
unionization or wage determination with industry patterns of market power. However, these
studies did not assess the impact of macroeconomic factors. Inspired by Fischer (1977a,
1977b) and Gray (1976), empirical macroeconomic studies of wages and indexation have
focused on traditional macroeconomic factors
(such as inflation and aggregate supply shocks)
but have ignored changes in market structure or
the degree of product market competition (for
example, see Ghosal and Loungani 1996).
Nominal Wage Contracts
The theoretical framework implies, under
the assumption of constant money growth, that
the use of nominal wage contracts is declining
in the variances of aggregate supply and
demand shocks and in the degree of product
market competition. Consistent with this model,
Duca and VanHoose (1998b) find that changes
in the unionized share of private-sector workers
(a proxy for nominal wage contracts) are negatively related to the variance of real oil prices (a
proxy for the aggregate supply shock variance),
the inflation rate (a proxy for aggregate demand
shock variance), and the inverse of an adjusted
profit-share measure (a proxy for the degree of
goods market competition).6
Changes in the cross-sectional pattern of
unionization also support the view that greater
market competition reduces the use of nominal
wage contracts. Some sectors are more suited to
such contracts than others due to sector-specific
conditions, which, at a point in time, can
account for differences in unionization across
industries. However, changes in how much
competition a sector faces relative to others may
explain why unionization rates have declined
faster in some sectors. Indeed, data available
since the early 1980s show that the largest
declines in unionization have been in sectors
facing increased foreign competition or in deregulated sectors (Figure 8).7 Table 1 shows that
many U.S. industries have been deregulated
since the late 1970s, suggesting that competition
has become tougher in product markets, not
only for traded goods but also for nontraded
services. Note that most of the overall drop in
unionization since the early 1980s is the result
of falling unionization rates within sectors,
rather than shifts in jobs from more unionized
industries to less unionized ones.8
The results are also consistent with a
Òrent-sharingÓ theory of unions (Layard, Nickell,
12
and Jackman 1994; Oswald 1982) and with
microeconomic studies that test for links
between firm monopoly power and unionization (for citations, see Mason and Bain 1993).
According to the rent-sharing approach, imperfect competition or pricing power creates excess
profits for a firm, which gives workers an incentive to incur the costs of unionizing. By forming
a union, current workers can restrict the potential entry of other workers and thereby gain
enough negotiating leverage to induce the
firm to share excess profits by paying above-
market wages. However, if the market structure
changes so that new firms can more easily enter,
then excess profits are bid down and there are
fewer rents to share. From this perspective,
deregulation and foreign competition have
greatly reduced the economic benefits of unionizing. The shortcoming of rent-sharing models
relative to the framework sketched here is that
existing rent-sharing models tend to ignore that
American unions generally negotiate only partially inflation-indexed wage contracts whose
optimality is also affected by supply shocks.
The advantage of the rent-sharing approach is
that its assumption of restricted labor supply
within a given sector can account for the
tendency of union wages to be higher than
nonunion wages.
Wage Indexation
The theoretical model implies that the use
of indexation in wage contracts should be increasing in the variance of aggregate demand
shocks, decreasing in the variance of aggregate
supply shocks, and decreasing in the degree
of product market competition. Consistent with
these predictions, Duca and VanHoose (forthcoming b) find that the overall incidence of
indexation clauses in union contracts is negatively related to the variance of real oil prices,
positively correlated with the inflation rate
and squared inflation expectation errors of
households, and negatively related to the inverse of an adjusted profit-share measure.
Indeed, Duca and VanHoose (forthcoming b)
find that changes in the overall use of indexation in contracts are better tracked by an empirical model that adds the degree of product
market competition to a more conventional
empirical model having only measures of aggregate supply and demand shock variances. As
with unionization rates, the cross-sectional pattern of declines in indexation are most pronounced in industries that either face foreign
competition or have been deregulated since the
late 1970s.
Table 1
Many U.S. Industries Have Been Deregulated Since the 1970s
SIC Industry* Major Deregulatory Steps
Agriculture Ñ
Mining Oil and gas: oil prices deregulated by a series of
presidential executive orders beginning in 1976;
natural gas prices deregulated by the Natural Gas
Policy Act of 1978.
Construction Ñ
Manufacturing Increased openness to trade, partly from the General
Agreement on Trade and Tariffs (1979, 1993), the
CanadaÐU.S. Free Trade Agreement (1989), and the
North American Free Trade Agreement (1994).
Transportation Trucking: truck rates liberalized in the late 1970s and
deregulated by the Motor Carrier Act (1980).
Airlines: the Airline Deregulation Act (1978) allowed
entry in 1982 and deregulated airfares in 1983.
Railroads: deregulated by Interstate Commerce
Commission liberalization of rail rates in the late
1970s and the Staggers Rail Act (1981).
Communications Telephones: largely deregulated following the AT&T
court settlement of 1982.
Cable television: deregulated in a series of Federal
Communications Commission rulings in the late 1970s
and by the Cable Television Deregulation Act (1984).
Telecommunications: partly deregulated by the
Telecommunications Act (1996).
Wholesale Ñ
Retail Ñ
FIRE (finance, insurance,
and real estate)
Banking: partly deregulated by the Depository
Institution Deregulation and Monetary Control Act
(1980) and the GarnÐSt. Germain Depository
Institutions Act (1982).
* Standard industry classification (SIC) of sectors at the one-digit-level classification code.
SOURCES: Winston (1993); authorÕs compilations.
Profit Sharing
Profit sharing has risen dramatically since
the early 1980s, as seen in Figure 3. As shown
by Bell and Kruse (1995), most of these profit-
sharing provisions include employee stock ownership plans or profit-based contributions to
thrift plans but make relatively little use of non-
deferred forms of profit sharing, such as cash
bonuses.
Deferred profit sharing is more common
because most workers do not have sufficient
wealth to see their weekly take-home pay vary
with market conditions. They are, however, better able to handle profit volatility over the long
run, such as in the form of variable, but cumulative, contributions to their retirement accounts.
Nevertheless, recent salary and Federal Reserve
Beige Book surveys indicate that annual
base/hourly pay is increasingly being comple-
FEDERAL RESERVE BANK OF DALLAS 13 ECONOMIC REVIEW FOURTH QUARTER 1998
Figure 9
Profit Sharing Rises in Manufacturing and
Deregulated Industries
Percent of workers with pension plans
45
40
35
30
25
20
15
10
5
0
Manufacturing
Other private industries
Deregulated industries
Õ93Õ92Õ91Õ90Õ89Õ88Õ87Õ86Õ85Õ84Õ83Õ82Õ81Õ80
SOURCES: Bell and Kruse (1995); authorÕs calculations.
mented by variable cash bonuses. This shift suggests that pay may be becoming more market
responsive in both the short run and long run.
The theoretical framework presented in
this article implies that under fiercer competition, profits are more closely aligned with
workersÕ market value, with profits more closely
reflecting prices minus unit labor costs (wage
costs adjusted for productivity). As a result,
profit sharing should trend upward with a measure of market competition, as seen in Figure 3,
where the competition measure rises as the relative demand for goods becomes more price
elastic. In this figure, the price elasticity of
demand is measured using the inverted after-tax
profit share of nonfinancial corporations,
adjusted for swings related to the business
cycle, oil prices, and exchange rates (Duca and
VanHoose, forthcoming a, forthcoming b).
Nevertheless, since available data cover a short
period and have a missing data point (1987), the
evidence is supportive, not conclusive. Thus, it
is unclear whether greater competition rather
than other factors has induced a rise in profit
sharing.
One way around this inference problem is
to compare deregulated or traded goods industries with others. Some sectors are more suited
to profit sharing than others because the nature
of work and the ability to monitor work vary
across sectors. Such factors would account for
why differences exist across sectors at a point in
time, while changes in the attitudes of different
generations might account for why profit sharing has risen overall. However, changes in the
relative degree of competition across sectors
might account for why profit sharing has risen
more in some industries than in others. Indeed
the biggest increases in profit sharing through
1993 have occurred in sectors facing increased
foreign competition, such as manufacturing, or
in deregulated sectors, such as transportation
(Figure 9). While inconclusive, these trends are
loosely consistent with the view that more
intense product market competition is boosting
the use of profit sharing.
CONCLUSION
Fiercer product market competition can
theoretically reduce the prevalence of nominal
wage contracts and of indexation in such contracts while boosting the use of profit sharing.
Arguably, product markets have generally
become more competitive in the United States
since the late 1970s, owing to increased foreign
competition in traded goods markets and the
deregulation of many nontraded sectors.
Consistent with this view, the after-tax profit
share of nonfinancial corporations has moved
within a lower range since the late 1970s, after
adjusting for swings in temporary factors and
net interest (Duca 1997).
Aggregate time-series evidence supports
the view that increased competition has
reduced the use of nominal contracts and indexation, as reflected in the declining rate of unionization and the falling incidence of CPI
indexation clauses in union contracts. Limited,
inconclusive data also support the view that
greater product market competition has boosted
the overall use of profit sharing. Consistent with
aggregate movements in labor practices and a
measure of the degree of goods market competition, industry-level data indicate that all three
of these trends are most evident in sectors that
have experienced either deregulation or increased foreign competition since the late
1970s. While more research needs to be done,
particularly using industry-level data, new theoretical arguments and empirical evidence supportÑbut do not conclusively proveÑthe view
that increased product market competition has
been reshaping AmericaÕs labor markets.
NOTES
I would like to thank John Benedetto for providing
research assistance; several human resource professionals, in particular Denise Duca and Joel Koonce,
for helpful discussions about changing norms in labor
compensation; and Evan Koenig, Stephen Prowse,
and David VanHoose for helpful comments. Any errors
are my own.
14
1
This is true if core inflation is adjusted for methodological changes in recent years that have reduced the
extent to which statistics have overstated consumer
price inflation.
2
This may have occurred in the 1960s when a run-up
in productivity growth initially offset rising wages stemming from low unemployment, but eventually accelerating wage growth overtook productivity growth,
causing unit labor costs and inflation to rise.
3
Accompanying this change has been an increased
use of temporary workers, a phenomenon examined
by Segal and Sullivan (1995, 1997).
4
Nevertheless, the incidence of sectoral demand
shocks may reduce contracting in extreme cases in
which workers place much more emphasis on minimizing deviations from market-clearing employment than
on minimizing deviations from the expected real wage.
5
In logs, the MRPL equals marginal revenue (pj) plus
the marginal physical product of labor (the sum of the
two log-linear supply shocks).
6
Prior studies (Evans 1991; Holland 1986) have found
inflation uncertainty to be increasing in the level of
inflation, which is consistent with arguments for pursuing price stability.
7
For details on deregulation, see Duca and VanHoose
(forthcoming a) and Winston (1993).
8
Following Duca and VanHoose (1998b), the time
series splices data from Troy and Sheflin (1985) with
data from the Bureau of Labor Statistics. Similar trends
in unionization rates are evident in recent estimates
by Freeman (1998).
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16
Privatization and the
Transition to a
Market Economy
Jason L. Saving
Economist
Federal Reserve Bank of Dallas
An effective privatization
must transfer ownership in
such a way that the new
private-sector owners and
managers have an incentive to
maximize profit, and this
incentive must be reinforced
by a legal structure that
encourages private-sector
competition for these firms.
Chinese President Jiang Zemin announced
in late 1997 that his nation would soon privatize
thousands of state-owned enterprises. The precise meaning of privatization in the Chinese
context is open to debate: one deputy minister
explained that the state might retain a majority
stake in the firms, and the editor of a communist newspaper said that expectations of a
Western-style ownership structure in the firms
had arisen from a ÒmisunderstandingÓ (Lyle
1997). Still, while information is scarce about
the details of the Chinese plan, it is clear that
any privatization effort in the worldÕs most populous country could have a major impact on the
global economy.
Given the distinct possibility of massive
privatization in China, it is natural to reexamine
economic reform in the postcommunist nations
of Eastern Europe and determine what lessons
may be drawn for China. The reform process in
these nations has been substantial: the private-
sector contribution to gross domestic product
(GDP) now exceeds 50 percent in nineteen of
the twenty-six states that once formed the Soviet
empire (European Bank for Reconstruction and
Development 1997), including each of the
Eastern European states outside the volatile
Balkan region (Table 1).1 The short-term pain
caused by economic reform has generally given
way to significant gains in per capita GDP
(Figure 1) and the possibility of membership in
multilateral institutions such as the European
Union and NATO.2 But can any lessons from the
Table 1
Share of GDP Derived from
Private Sources
1980 1988 1994 1997
Czech Republic <1.0 <1.0 65 75
Hungary 3.5 7.1 55 75
Poland 15.6* 18.8* 55 65
Romania 4.5 Ñ 35 60
Russia <1.0 <1.0 50 70
Slovakia <1.0 <1.0 55 75
United States 79.4 79.6 81.1 82.0
* This is almost exclusively agricultural production
(Slay 1993).
NOTE: Czechoslovakia dissolved in 1993 and was
replaced by Slovakia and the Czech
Republic.
SOURCES: Patterson 1993; European Bank for
Reconstruction and Development
1994, 1997; Bureau of Economic
Analysis.
FEDERAL RESERVE BANK OF DALLAS 17 ECONOMIC REVIEW FOURTH QUARTER 1998
Figure 1
Real GDP Per Capita
U.S. dollars
6,0001996199519941993199219911990
Slovakia
RomaniaPoland Hungary
Czech Republic
5,000
4,000
3,000
2,000
1,000
0
experiences of these Eastern European nations
be applied to other countries embarking on the
road of economic reform? Also, was the road to
privatization in these nations paved with serious
mistakes others might be able to avoid?
In discussing these questions, it is important to define precisely what is meant by privatization. While privatization occurs whenever
the ownership of a firm is transferred from the
government to the private sector, the purpose
of this transfer is to help create a competitive
economic environment in which firms strive to
increase efficiency and maximize profit. Thus,
an effective privatization must transfer ownership in such a way that the new private-sector
owners and managers have an incentive to maximize profit, and this incentive must be reinforced by a legal structure that encourages
private-sector competition for these firms. These
are the issues this article discusses.
INFORMATION AND PRIVATIZATION IN PRACTICE
In theory, privatization is a relatively simple process in which potential investors evaluate the profit potential of each firm, choose
those in which to acquire shares, and then manage the firms in a way that maximizes their
return.3 In practice, however, this model suffers
from limitations when applied to the transition
from communism to a market economy. In general, formerly communist citizenries are likely
to be less familiar with market economics than
their capitalist counterparts, and some commentators have suggested that this unfamiliarity
could lead them to make bad investment decisions (Brada 1992). This perception is not without foundation. For example, a 1998 Moldovan
newspaper headline marveled that the Òprivate
sector survives even though it gets no state
supportÓ (Bird 1998), and it is estimated that
one-sixth of AlbaniaÕs population may become
bankrupt because of investments in pyramid
schemes (Percival 1997). Such examples suggest
that economic education may be important to
the success of privatization.
In addition, formerly communist citizenries face special problems in attempting to evaluate the net worth of to-be-privatized firms.
Balance sheets for such firms were not kept
according to Western norms, often deliberately,
so as to shield the poor performance of high-
ranking party functionaries who were appointed
as managers during the communist era but wish
to retain their positions after privatization
(Brada 1996, Tirole 1994). Moreover, the division of assets among such companies is not
clearly delineated, so that a potential investor
during the transition period could not be certain
which assets would end up with a company and
which would remain with the state (Bolton and
Roland 1992). In addition, the transition to a
market economy would almost certainly cause
an enormous reallocation of resources across
sectors of the economy, making it difficult for
citizens to gauge a firmÕs future performance
even if communist-era balance sheets were
available.
A final problem relates to communist-era
informational asymmetries between the ordinary citizen and the party elite. Information is a
closely guarded commodity under communist
systems, and government officials commonly
possess an enormous amount of information of
which ordinary citizens are unaware (Blanchard
and Layard 1992). In the aftermath of communism, then, a citizenÕs information about state-
run enterprises would be primarily a function of
past affiliations with a now-discredited state.
This implies that the group of citizens best able
to evaluate the profit potential of state-run firms
is composed of precisely those individuals society
would least like to prosper.
Yet there is widespread agreement that
shares in state-owned enterprises should be
given to the public whose efforts created the
enterprises. These Òmass privatizationÓ programs
are regarded as the most egalitarian method of
privatization because each citizen profits from
them (Grime and Duke 1993). Also, giving each
citizen a stake in privatization increases public
support for the program and reduces the governmentÕs ability to renege on its privatization
commitments (see the box entitled ÒCredible
Commitments and PrivatizationÓ).
Is there a socially optimal distribution of
ownership shares when ordinary citizens are
18
unable to evaluate the prospective financial performance of state-run enterprises but communist functionaries are capable of making such
evaluations? Perhaps surprisingly, there are
some conditions under which this question can
be answered in the affirmative. For example,
suppose that shares are to be divided among
the citizenry subject to three conditions:
1. Every share must be distributed to a citizen.
2. The expected profit of each citizen
must be equal.
3. The risk (variance) borne by each citizen must be equal and must be as low
as possible, subject to all other conditions.
Only one portfolio of shares meets these
three criteria: a distribution in which each citizen receives an equal percentage of each enterprise.4 Moreover, such a distribution can be
implemented even if those in charge of privatization cannot evaluate the financial viability of
state-owned firmsÑan important consideration
in countries where government economic decision-making prowess is at best questionable.
There are no examples of large-scale privatizations in which each citizen was given an
equal share in each state-owned enterprise.
However, the equal-share distribution is a special
case of the voucher-based privatization programs
implemented by, among others, Poland and
Czechoslovakia (which split into Slovakia and the
Czech Republic on January 1, 1993). In these
mass privatization programs, each citizen received an equal amount of purchasing power,
which could be used to obtain shares of state
enterprises. However, these and other mass privatization programs must confront certain problems.
HOLDING COMPANIES AND
EFFECTIVE PRIVATIZATION
Problems of Dispersed Ownership
Mass privatization carries with it a serious
problem: no single investor has the ability to
oversee management. Since managers do not
own their firms, shareholders must oversee
managers to ensure that management makes
every effort to maximize profit (Jensen and
Meckling 1976). However, mass privatization
can produce a situation in which an enormous
number of individuals hold only a small number
of shares. Under this scenario, no single investor
would have sufficient incentive to monitor managerial activity, even though every investor
would gain by such monitoring (Gray 1996).
Without a resolution to this problem, firms
Credible Commitments and Privatization
Privatization helps promote economic growth by ensuring that firm owners have
an incentive to maximize profit. However, one important aspect of any privatization
program is the possibility of revocation (Weingast 1995). Unless those who become
owners of privatized enterprises believe the government will allow them to keep the
fruits of their labors, there is little reason to believe these owners will invest time and
effort in their enterprises.
The importance of political commitment to the privatization process can be illustrated through an examination of RussiaÕs New Economic Policy.* Shortly after the
communist takeover of 1917, Bolshevik leaders confiscated private farmland in what
they called the Òcrusade for bread.Ó Though the peasantry was ordered to continue
working the fields, all farm output would go to the state rather than the workers. This
policy reduced peasant effort to such an extent that mass starvation ensued, followed by peasant riots that began to threaten the survival of the Bolshevik regime. In
response, Lenin introduced a partial privatization of farmland and a partial restoration of farmersÕ right to sell excess produce to ordinary Russians, arguing that peasants would not work at maximum efficiency unless they were able to reap the
rewards of their labors.
But would the communist regimeÑwhich had previously viewed private property as anathemaÑbe willing to commit to the New Economic Policy for the foreseeable future? Nove (1992) recounts the words of a communist official who complained
New Economic Policy supporters Òdemand of us a promise that we will never, i.e. not
in 15 or 20 years, confiscate or expropriateÓ farmland, to encourage peasant farmers
to work without fear that the state would seize their crops and confiscate their land.
This the official refused to do: in his words, expropriation of farmland by the state
would occur Òwhen the time comes for so doing.Ó
The productivity gains from the New Economic Policy were short-lived, partly
because of these fears. Farmland was then reconfiscated in a new effort to abolish
private farming.
* Details of the New Economic Policy are taken from Nove (1992).
might perform no better after privatization than
they had before privatization.5 Such a situation
points to the difference between the act of privatization (transferring ownership to the private
sector) and an effective privatization.
The oversight issue is especially problematic because of the temptation to retain communist-era managers during the transition
period and let investors decide later whether to
remove them. In Russia and the Ukraine, such
holdover managers routinely used bribes and
intimidation to forestall their replacements
(Roland 1994), a maneuver that has been
dubbed Ògrab-izationÓ by the media (Seely
1993). In Hungary, managers often held positions in local government, and the patronage
opportunities afforded by such an arrangement
encouraged local governments to resist both
managerial replacement and the overall privatization effort (Bolton and Roland 1992). Finally,
some managers across Eastern Europe simply
seized firms from the state and began operating
them as private businesses (Voszka 1993). This
Òspontaneous privatizationÓ of firms was aided
by a lack of information, even on the part of
government, about which assets belonged to
the state (Boycko, Shleifer, and Vishny 1994).
When owners were able to replace management despite these problems, empirical evidence suggests such replacement helped
FEDERAL RESERVE BANK OF DALLAS 19 ECONOMIC REVIEW FOURTH QUARTER 1998
increase the economic performance of privatized firms in Eastern Europe (Dyck 1997). But
in a world of dispersed ownership, such
replacement may be unlikely to occur.
Holding Companies as a Solution
To address these concerns, many economists have recommended the creation of a small
number of powerful shareholders (Bolton and
Roland 1992). Because firm performance would
substantially impact the profit of these shareholders, they would (at least theoretically) have
an incentive to control management (Gray
1996). At the same time, citizens could invest
in the diverse portfolios of these powerful
shareholders, rather than in a single company
(Boycko, Shleifer, and Vishny 1994). Further, the
powerful shareholders would presumably have
a much greater ability to obtain financial information about the firms to be privatized and,
therefore, a greater ability to pick a reasonable
ownership portfolio.
Perhaps the most obvious candidate for
the role of Òpowerful shareholderÓ would be
government. As the single most powerful entity
in a country, government would have the necessary size and scope to exert pressure on management. Moreover, because governments in
formerly communist countries are far more
intrusive into the lives of citizens than are governments in the West, government officials in
these nations would be relatively adept at
obtaining information and pressuring firms.
However, governments have a multiplicity of
interests, which include running an efficient
firm but also include minimizing unemployment
and facilitating political patronage. Presumably,
there would be no reason to discuss privatization unless governments were failing to operate
efficient enterprises, but a government that fails
in this capacity would not be an appropriate
choice for powerful shareholder.
The other obvious candidate for fulfilling
the responsibilities of a powerful shareholder
would be the indigenous banking sector.6 After
all, these banks had made loans to newly privatized enterprises before those enterprises were
private. This suggests that the banking sector
would have knowledge of the firmsÕ financial
status and future prospects (to gauge the ability
to repay a loan) as well as an especially strong
interest in the firmsÕ financial future (to ensure
such repayment). However, lending decisions
under communism were based on political
rather than economic considerations, and it was
known that loans not repaid by borrowers
would be covered by the state. Thus, communist-
era banks had no incentive to investigate the
financial viability of firms to which they made
loans or to hire people who possessed any particular aptitude for such investigations. Moreover, since it is almost impossible for bank
privatization to precede the privatization of
other enterprises, distributing firms across the
banking sector would amount to continued
nationalization rather than privatization.
With neither the national government nor
the banking sector able to fulfill the responsibilities of the powerful shareholder during the
transition from communism, privately run holding companies would become the most natural
alternative. Econometric evidence from Britain
suggests that holding companies can be an
effective means of enforcing managerial productivity after privatization (Blanchard and
Layard 1992). However, holding companies
alone are not sufficient to ensure effective privatization, as recent experiences in Chile and
Russia have demonstrated. Chile attempted
large-scale privatization shortly after the ascension of Pinochet, and the result was an enormous concentration of ownership shares among
private financial institutions that were subsequently rendered bankrupt by an economic
downturn (Bolton and Roland 1992). In Russia,
voucher privatization was hampered by the
presence of bogus investment funds that absorbed citizen investments and acquired firms in
the name of those citizens, but then vanished
when payment was requested by the state
(Seely 1993). Both Chile and Russia were forced
to embark upon costly reprivatization programs.
These examples suggest that the proper
implementation of holding companies is of crucial importance. How did the design of the
Polish and Czechoslovak privatizations compare
in this respect? Recognizing the pitfalls associated with mass privatization, the Polish proposal
mandated the creation of between ten and
twenty holding companies (Blanchard and
Layard 1992). Responding to concerns about a
lack of information about the financial performance of state-owned firms, each holding company was to be assigned a distribution of
ownership shares by the government (Boycko,
Shleifer, and Vishny 1994). Finally, to ensure
managerial oversight, at least one-third of the
shares of each state-owned firm would be given
to a single holding company that would be
expected to oversee the firmÕs management.
Each citizen would receive one share in each
holding company but none in individual firms.
The Czechoslovak proposal, in contrast,
did not mandate the creation of holding com
20
panies. Instead, each citizen was to receive a
certain number of voucher points, which could
be used to obtain shares in individual firms.
These points could also be entrusted to holding
companies if such companies were to emerge
from the private sector, but the government
would not itself create them (Brada 1992).
Voucher holders would then expend points to
acquire shares in particular enterprises.
The Polish plan might appear to be the
more effective means of privatization because it
mandated a reasonable ownership structure and
minimized the informational problems associated with citizen participation. In reality, however, the Polish plan was stymied for years
because political pressures prevented the government from choosing how to allocate ownership shares to holding companies (Roland
1994). In Czechoslovakia, on the other hand,
privately run investment funds quickly arose in
response to an enormous demand for such
funds by consumers. Indeed, more than half of
all Czechoslovak citizens entrusted their vouchers to these funds, whose portfolios were determined through market mechanisms rather than
the political process (Kotrba and Svejnar 1994,
Grime and Duke 1993). Ironically, Czechoslovakia emerged with an ownership structure
reasonably close to the structure desired by
Poland without any government mandates to
that effect, while PolandÕs attempt to mandate
such a structure almost derailed its privatization
program entirely.
The examples given here permit certain
conclusions to be drawn regarding holding
companies. First, citizens recognize the problems associated with mass privatization and, as
the Czechoslovak experience demonstrates, will
solve them through holding companies if given
the opportunity to do so. Second, government
can assist in this process by guarding against
fraudulent holding companies, something the
Russian state failed to do in its initial privatization effort. However, efforts to move beyond
this oversight could harm a privatization program even if such efforts were well-intentioned,
such as the Polish governmentÕs desire to
ensure that holding companies would be created and would receive the proper distribution
of shares. When states seek to create holding
companies, the Polish experience suggests that
policymakers must have a firm consensus on
precisely how shares will be distributedÑperhaps by implementing an equal-share distribution at the holding company level and then
giving each citizen an equal share of each holding company.
LEGAL STRUCTURE AND
PRIVATE BUSINESS CREATION
A successful privatization program transfers ownership from government to the private
sector in a way that ensures proper managerial
oversight of the privatized firms. However,
these firms will be tempted to behave as
monopolies unless they face competition from
other private-sector firms. Such competition
cannot form as long as communist-era constraints on private business creation are maintained. These constraints range from a ban on
the private ownership of land to the harassment
of private-sector banks to confiscatory tax
regimes. They even include price controls,
which are not typically associated with private
business creation but nevertheless play an
important role in facilitating competition.
Direct Constraints
There are several reasons to suppose that
constraints on private business creation would
diminish the economic effects of privatization.
One reason is that constraints on private business creation lead to monopolistic industries
(Feinberg and Meurs 1994). Although privatization programs move government-run monopolies into the private sector, they do not in and of
themselves create competitive markets. Unless
entrepreneurs are free to create competing
firms, newly privatized companies will not face
sufficient financial pressure to improve quality
and reduce prices. In such a noncompetitive
environment, privatization could change firm
ownership without changing firm behavior.
Constraints on private business creation
are also likely to harm consumers who wish to
obtain goods deemed unimportant during communist rule. Communism emphasizes heavy
industry over agriculture and the service sector,
which suggests that the public sector would
contain a disproportionately high number of
heavy-industry firms but a disproportionately
low number of service-sector and agricultural
firms (Bolton and Roland 1992). In fact, the
employment share of heavy industry relative to
these sectors was estimated to be 50 percent
higher in Eastern Europe than in comparable
developed economies (European Bank for
Reconstruction and Development 1997). Thus,
private business creation is needed to shift the
overall composition of firms in the economy
toward services and agriculture and thereby satisfy consumer demand.
Another effect of constraints on private
business creation is to exacerbate unemploy-
FEDERAL RESERVE BANK OF DALLAS 21 ECONOMIC REVIEW FOURTH QUARTER 1998
Table 2
Qualitative Competitiveness Measures, 1997
Removal of Price
Privatization entry barriers liberalization
Czech Republic Near OECD Substantial Substantial
Hungary Near OECD Substantial Substantial
Poland Near OECD Substantial Substantial
Romania Substantial Some Substantial
Russia Substantial Some Substantial
Slovakia Near OECD Substantial Substantial
NOTE: Near OECD means near normal Western levels.
SOURCE: European Bank for Reconstruction and Development 1997.
ment problems that occur during the privatization process. Because communist doctrine
emphasizes full employment, state-owned firms
are encouraged to employ workers even when
those workers become unprofitable for their
companies (Feinberg and Meurs 1994). This
suggests that private owners would almost certainly need to lay off workers. Unless these individuals are free to start their own businesses
and free to work for newly created businesses,
the unemployment created by privatization
could cause rather severe social difficulties,
especially given the near-total absence of a
social safety net in these countries.
Finally, constraints on private business
creation place an inordinate emphasis on successful privatization. Even though the theoretical issues involved in privatization are relatively
simple, designing a privatization program that
successfully translates theory into effective privatization is extremely difficult. By definition,
private business creation lessens the economic
influence of newly privatized firms. Therefore,
business creation acts as a sort of safety net for
poorly designed privatization programs and
thereby assists in the transition to a market
economy.
Price Controls
Before the fall of the Iron Curtain, goods
communist officials deemed necessary were
often priced significantly lower than comparable goods in the West, while goods deemed
unnecessary were often priced significantly
higher (Arrow and Phelps 1993). It is, therefore,
not surprising that price liberalization was one
of the first issues with which the postcommunist
states of Eastern Europe had to contend.
Economists have argued that price liberalization
is essential to the development of a market
economy because prices are the mechanism
through which entrepreneurs determine what to
produce. Based on this advice, price reform was
made the first priority of the postcommunist
Solidarity government in Poland and a high priority in most other Eastern European states
(Vickers and Yarrow 1991).
While price controls are most commonly
criticized for obscuring producersÕ ability to
know which products to produce, price controls
also act as a barrier to private business creation
and therefore affect whether an entrepreneur
produces at all. When the state sets artificially
low prices in a particular industry, entrepreneurs have little incentive to set up firms in that
industry because they cannot earn a sufficiently
high rate of return on their investment. Thus,
raising prices can actually help consumers by
hastening the arrival of competitors, which will
in turn eliminate the shortages endemic to communism and ultimately lower prices as well.
Eastern European Experience
The privatization process is nearing completion across the core states in Eastern Europe,
and constraints on private business creation in
these states have been substantially reduced
(Table 2). However, private business creation
was hindered in a variety of ways during the
transition period. In Russia, market entry was
discouraged Òby a variety of technological,
administrative, and other obstaclesÓ (Capelik
1992). In Hungary, market entry was hampered
by a government policy under which large state
banks ignored the private sector in favor of
state-owned enterprises; additionally, any loans
by private-sector banks to private-sector businesses could be deemed improper banking
practices punishable by closure of the bank in
question (Pataki 1993). And in Romania, government regulations impede market entry to
such an extent that many privatized firms continue to be run as monopolies (Melloan 1998).
On the other hand, private-sector economic activity exploded in the Czech Republic
as a result of rapid postcommunist market liberalization (European Bank for Reconstruction
and Development 1997). For example, the
Czech RepublicÕs private-sector share of GDP is
almost on a par with that of the United States
(Table 1 ). Private-sector economic activity also
rose in Poland and Hungary, where successful
communist-era experiments in private-sector
legalization helped persuade postcommunist
policymakers to adopt market liberalization
shortly after the fall of the Soviet Union
(Johnson 1994). These three countries have had
the fastest-growing economies in Eastern
Europe since the transition from communism
(Figure 1). While one cannot demonstrate conclusively that a favorable climate for private
22
business creation is responsible, the experience
of these countries is consistent with the idea
that constraints on private business creation can
hinder growth.
The abolition of price controls occurred in
a more uniform fashion in Eastern Europe.
Within a few years after the fall of communism,
price controls had been sharply reduced across
the region (Table 2). This resulted in the virtual
elimination of shortages and an eventual increase in product quality to near-Western levels.
Reversion to the previous regime has been a
possibility only in Russia, where many expressed hope that firms would voluntarily limit
their price increases in the name of protecting
the consumer (Arrow and Phelps 1993). Indeed,
policymakers almost reinstated strict price controls in 1993 to counter what one legislator
called the ÒgreedÓ of producers, and the legislature enacted a number of provisions to punish
those deemed to have raised prices too far or
too fast (Bush 1993). This lack of political commitment to reform deterred entry and shifted
business toward the black market (which has
seen astonishing growth in Russia) while prolonging the presence of queues that in turn
have generated widespread public dissatisfaction with the reform effort.7 Several Russian
regions reintroduced price controls in 1998 to
quell this dissatisfaction, and the national
government has discussed doing the same
(LaFraniere 1998). Such a move would reduce
competition in the Russian economy and, ironically, exacerbate many of the economic problems to which the public objects.
CONCLUSION
This article explores problems and possibilities associated with privatization and the
transition to a market economy. In it, I suggest
that privatization at its most basic levelÑthe
distribution of shares from the government to
the private sectorÑis difficult to achieve and
insufficient to bring about economic growth. I
also consider the importance of appropriate
owner/manager incentives and conclude that
privately created holding companies may be the
best way to ensure that de jure privatization
becomes effective privatization. Finally, I consider the importance of legal constraints on private business creation and conclude that a
competition-enhancing legal framework is vital
to the success of privatization.
What lessons can be learned from the
Eastern European privatization experience and,
perhaps, applied to emerging economies such
as ChinaÕs? One such lesson is that the design of
a privatization program is as important as the
economic theories the program incorporates.
Unlike privatization in the West, which typically
involves a single firm whose financial performance has been evaluated by independent
auditors, the transition from communism involves the simultaneous privatization of hundreds of firms for which even the most basic
balance-sheet information is likely to be unavailable. Additionally, a dispersal of ownership
across many citizens could produce a situation
in which shareholders would be unable to exercise effective oversight of management. One
way to overcome this problem would be
through the creation of holding companies in
which each citizen could invest. For example,
heeding the suggestion of economists, both
Poland and Czechoslovakia made holding companies a centerpiece of their privatization programs. However, equally strong commitments to
the principle of holding companies did not
result in equal success with their implementation. Holding companies played an enormous role in the success of the Czechoslovak
program but nearly destroyed the Polish
scheme. Such seemingly small changes in
implementation could have enormous consequences for Chinese privatization.
Of particular importance is the claim that
Chinese privatization might not move a majority
interest in state-owned firms into the private
sector. If the Chinese government were to maintain a majority stake in a particular ÒprivatizedÓ
enterprise, it could thwart efficiency-enhancing
measures at that company if the measures were
likely to increase unemployment. The government could also block the firm from entering
new markets if those markets were already
served by a government-owned firm. It could
even bankrupt the firm if the private-sector
shareholders were to resist the directions in
which the government wished to take the firm.
One might hope the government would behave
as if it were a private-sector individual, but the
only way to guarantee such behavior by the
owners of privatized firms would be to ensure
that every owner is a private-sector individualÑ
which would be inconsistent with a privatization plan in which the government releases only
a minority of ownership shares to the public.
Another lesson is that privatization, while
important, is not sufficient to create a market
economy. Eastern European governments focused on privatization as a quick fix, something
that could be executed quickly and would bring
about effective competition just as quickly. Yet
FEDERAL RESERVE BANK OF DALLAS 23 ECONOMIC REVIEW FOURTH QUARTER 1998
privatization does not by itself create competition. If communist-era restraints on private business creation were to be maintained in China,
entrepreneurs would be unable to compete
against newly privatized companies. This could
mean that privatization would only convert government-run monopolies into privately held
monopolies, with minimal employment opportunities for workers laid off during the privatization process. Such a result might exacerbate
the unemployment shocks associated with the
transition to a market economy without providing any of the efficiency gains that result from
competitionÑprobably the worst imaginable
outcome for those who wish to help unleash
the Chinese economy through privatization.
Chinese policymakers have much to learn
from the Eastern European privatization experience. As China embarks upon its ambitious
privatization program, it remains to be seen
whether its leaders will look to Eastern Europe
for guidance on how to enact a successful programÑor whether they will simply repeat
Eastern EuropeÕs mistakes.
NOTES
I would like to thank Steve Brown, Steve Prowse, Lori
Taylor, and Mine YŸcel for helpful comments.
1
These Eastern European states are the Czech
Republic, Hungary, Poland, Romania, and Slovakia.
2
A study by Ali (1997) finds that increased economic
freedom generally leads to increased economic
growth.
3
One example is the landmark 1984 privatization of
British Telecom (Financial Times 1995).
4
This is a standard portfolio-theory result applied to
privatization. See Sharpe (1970) for a more general
discussion of portfolio theory.
5
Hansen (1997) presents an alternative view in which
mass privatization is desirable precisely because no
single investor has the power to oversee management.
According to this view, managers who face no shareholder oversight can transfer any profit from the shareholders to themselves, which gives managers a
powerful incentive to maximize profit.
6
See Dittus and Prowse (1996) for an interesting and
informative discussion of this issue.
7
Responding to this dissatisfaction, the Russian legislature passed a nonbinding resolution in June 1997
that called for the renationalization of many previously
privatized companies. The nonbinding measure
passed by a vote of 288 to 6 (Radio Free Europe/
Radio Liberty 1997).
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565Ð97.
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FEDERAL RESERVE BANK OF DALLAS 25 ECONOMIC REVIEW FOURTH QUARTER 1998
Global Warming
Policy: Some
Economic
Implications
Stephen P. A. Brown
Senior Economist and Assistant Vice President
Federal Reserve Bank of Dallas
Compliance with the
Kyoto accord would
represent a sizable
reduction in the
use of fossil fuels.
Many analysts believe that adverse climate
changes in the form of global warming areÑ
or soon will beÑunder way as the result of
anthropogenic emissions of greenhouse gases.
(See the box entitled ÒWhat Is Global Warming?Ó) The largest such source of these gases is
carbon dioxide (CO2) resulting from the growing consumption of fossil fuels (petroleum
products, natural gas, and coal).1 Consequently,
the conservation of fossil fuels figures prominently in strategies to reduce CO2 emissions.
Increasing concerns about the extent of
global warming and its potential consequences
culminated in a United Nations conference in
Kyoto, Japan, in late 1997. Prior to the conference, President Clinton proposed that the
United States join with other industrialized
countries in setting a target for reducing CO2
emissions in each country to 1990 levels by
2010. By the end of the conference, emissaries
from the industrialized countries had agreed to
a target 7 percent below 1990 levels by 2010
and to make further reductions in subsequent
years. Developing countries would be expected
to reduce their CO2 emissions in future years as
their incomes rise.
As shown in Figure 1, the U.S. Department
of Energy has projected that CO2 emissions from
the consumption of fossil fuels in the industrialized countries will have increased about 30 percent from 1990 to 2010. Therefore, compliance
with the Kyoto accord would represent a sizable
reduction in the use of fossil fuels from what
could otherwise be expected. My analysis indicates that the developing countries would consume nearly 12 percent of the amount of fossil
fuels the industrialized countries must conserve
to comply with the Kyoto accord. The net effect
Figure 1
Annual Carbon Emissions, 1990Ð2015
Billions of metric tons
12201520102005200019951990
World
Effect of the
Kyoto accord
Effect of the
Kyoto accord
OECD countries
10
8
6
4
2
0
SOURCES: Energy Information Administration (1997); authorÕs
calculations.
26
What Is Global Warming?
would be to slow the growth of global CO2
emissions from the projected 45 percent to 30
percent between 1990 and 2010.2 Some worry
that compliance with the Kyoto accord would
impose drastic costs on the industrialized countries with little proven benefit. Others worry the
Kyoto targets are too modest to prevent costly
environmental problems.
These concerns raise several questions.
What is the rationale for government intervention in markets to reduce CO2 emissions? By
how much does economic analysis suggest that
the United States reduce its CO2 emissions, and
how do President ClintonÕs proposal and the
Kyoto accord compare with what is optimal?
The former question can be answered with
simple economic theory. The latter question can
be answered by combining estimates of the
economic benefits of reducing CO2 emissions
with the opportunity costs of doing so.
CALL FOR GOVERNMENT POLICY
Although nature contributes its own CO2
to the atmosphere, policy is more easily
directed to the CO2 contributed by human activity. The principal way people contribute to
atmospheric CO2 is through the consumption of
carbon-based fuels. These fuels include petroleum products, natural gas, coal, and wood.
Jointly, the first three are often identified as
Òfossil fuels.Ó
Deforestation is another way people contribute to increased levels of atmospheric CO2.
Scientists estimate that the worldÕs forests remove about one-third of the current CO2 emissions from fossil fuels. Thus, large reductions in
the worldÕs forests could significantly affect the
atmospheric levels of CO2. Nevertheless, recent
changes in the earthÕs forests have had little
effect on atmospheric CO2 in comparison with
the effects from fossil fuel consumption.
At the pragmatic level, the call for government action on global warming comes from the
concern that rising consumption of carbon-
based fuels will increase levels of atmospheric
CO2, which will lead to warmer temperatures
that could harm the environment. At a more
analytical level, however, when consumers act
individually they lack an incentive to consider
the global side effects resulting from their consumption of carbon-based fuels. Taken collectively, individual actions could be contributing
to greater emissions of CO2 than are desirable
from the perspective of economic efficiency.
To some extent, the divergence between
individual and global interests can be seen in
Global warming is a scientific theory or scenario in which increased levels of
atmospheric CO2 are linked to generally rising temperatures around the world. To
better understand global warming, start with the greenhouse effect. Sunlight heats
the earth, but the earth would be far cooler if not for the presence of water vapor and
greenhouse gases in the atmosphere. These gases let sunlight through to warm the
earth but trap some of the heat escaping back into space in the form of infrared radiation. In this manner, the gases act like the glass walls and ceiling of a greenhouse.
Increasing the level of greenhouse gases in the atmosphere is like using thicker
glass in the greenhouse: less heat escapes. Many scientists believe the CO2 released by human activities is intensifying the greenhouse effect and contributing to
an increase in the earthÕs overall temperature. This general increase in the earthÕs
temperature is commonly known as global warming.
Many scientists and other people are concerned about global warmingÕs potential effect on the environment. Among the predicted consequences are increased
rainfall, melting polar ice caps, rising ocean levels, increased flooding, and widespread crop failure.
The evidence of global warming is inconclusive, but most scientists who study
the issue think that it is occurring to some degree. Nevertheless, there is considerable uncertainty about the magnitude of the change, whether CO2 is a contributing
factor, and the environmental consequences.
the debates that occurred at the UN conference
on global warming. The representatives of each
country jockeyed for advantage and criticized
each other for not doing enough. At the international level, debate has been exacerbated by
the fact that reducing energy consumption on a
global scale yields gains in the terms of trade for
energy-importing countries.
EVALUATING GLOBAL WARMING POLICY:
A COSTÐBENEFIT APPROACH
Economics offers two approaches for evaluating how much effort should be put forth to
reduce global warming. One approach is to
set an appropriate tax on carbon-based fuels.
Another is to use costÐbenefit analysis.
The costÐbenefit approach offers two
advantages. It allows us to consider more
directly the uncertainty about the benefits of
reducing CO2 emissions. It also allows representation of the wide range of debate about
global warming policy. Under this approach, a
reduction in environmental harm is the benefit
of reducing CO2 emissions. The foregone economic opportunities from using less fossil fuel
are the cost.
Benefits of Reducing CO2 Emissions
The benefits of reducing CO2 emissions
are the environmental damages that are avoided
by preventing rising concentrations of atmospheric CO2 that intensify the greenhouse effect
and boost global temperatures. Potential environmental damage from global warming
includes a variety of effects, from the impact on
FEDERAL RESERVE BANK OF DALLAS 27 ECONOMIC REVIEW FOURTH QUARTER 1998
Table 1
Reference Case Quantities, Prices, and Elasticities
Price elasticity of fuel at left agriculture and forests to the costs of coping
Quantity with respect to price of with more severe weather, flooding of coastal
(1015 Btu) Oil Natural gas Coal Other property, and increased disease.
United States An emerging literature attempts to evalu-
Consumption
ate the economic costs associated with the
Oil 42.5 Ð.72 .25 .03 .06
Natural gas 29.2 .25 Ð.72 .10 .06 potential environmental damage caused by CO2
Coal 22.8 .12 .63 Ð.96 .06 emissions. (For examples, see Fankhauser 1994;
Other 14.2 .05 .05 .10 Ð.50 Hope and Maul 1996; Nordhaus 1991a, 1991b,
Production
1992, 1993; and Peck and Teisberg 1993a,
Oil 17.9 .51
Natural gas 24.9 .51 1993b.) Analysts and researchers working in the
Coal 25.2 1.86 field must contend with several uncertainties:
Other 14.2 1.00 the extent to which these emissions will affect
Other OECD global warming, the environmental harm caused
Consumption by global warming, and the economic costs of
Oil 58.8 Ð.72 .25 .03 .10
those environmental effects.
Natural gas 34.2 .25 Ð.72 .10 .10
Coal 18.1 .12 .63 Ð.96 .10 The emerging literature provides estimates
Other 29.1 .05 .05 .10 Ð.50 of the benefits of reducing CO2 emissions. This
Production literature suggests the worldwide marginal bene-
Oil 25.7 .43
Natural gas 24.2 .43 fit from a reduction in CO2 emissions occurring
Coal 18.3 1.86 in 2010 plausibly ranges from $0 to $33.75 (in
Other 29.1 1.00 1995 dollars) per barrel of oil equivalent. (In this
C/EE/FSU case, barrel of oil equivalent refers to the CO2
Consumption emissions resulting from the consumption of a
Oil 17.8 Ð.225 .075 .01 .05 barrel of oil.) The literature also suggests that
Natural gas 33.2 .075 Ð.225 .04 .05 the most likely range for worldwide benefits is
Coal 13.1 .04 .20 Ð.31 .05
Other 6.5 .02 .04 .04 Ð.25 about $.92 to $6.61 per barrel of oil equivalent,
Production as is shown in Figure 2. The mean estimate is
Oil 20.4 .30 $2.86 per barrel of oil equivalent.3
Natural gas 43.3 .30 Given the considerable uncertainty about
Coal 14.3 1.24
Other 6.5 1.00 the benefits of reducing CO2 emissions, some
analysts have suggested that making the reduc-
OPEC
Consumption tions is similar to insurance in one important
Oil 11.3 Ð.72 .25 .00 .01 respect: the costs of reducing emissions are
Natural gas 5.6 .25 Ð.72 .00 .01 fairly well known, but the benefits cannot be
Coal .3 .12 .63 Ð.96 .10
known with any certainty.
Other .4 .05 .10 .10 Ð.50
Production
Oil 72.6 * Estimating the Costs of Reducing CO2 Emissions
Natural gas 5.6 .40 Completing the costÐbenefit analysis
Coal .3 1.65
requires estimates of the costs of reducing CO2
Other .4 1.00
emissions through conservation of fossil fuels.
Other LDCs Following several previous studies, marginal
Consumption
Oil 64.5 Ð.45 .15 .02 .08 cost estimates are obtained by using a welfare-
Natural gas 26.8 .15 Ð.45 .10 .08 theoretic framework built on top of a simulation
Coal 68.5 .08 .40 Ð.61 .08 model of world energy markets.4 Many analysts
Other 17.0 .04 .08 .08 Ð.50
use U.S. Department of Energy (DOE) projec-
Production
Oil 58.3 .43 tions as a reference standard for analysis, and
Natural gas 31.0 .43 the simulation model is calibrated to reproduce
Coal 64.7 1.86 the DOEÕs 1997 projections for world energy
Other 17.0 1.00
market conditions in 2010, as shown in Table 1.
World reference prices $/106 Btu $/standard unit The data in the table represent one of many
Oil $3.519 $20.41 per barrel possible world energy outlooks for 2010.5
Natural gas $1.9553 $2.01 per Mcf
Coal $ .7924 $16.919 per short ton Table 1 also summarizes representative
estimates of the long-run supply and demand
* OPEC adjusts its production to maintain a constant share of the oil market. responses to prices for the major regional areas
Prices are in 1995 dollars.
in the analysis. These estimates are derived from
a variety of sources. The oil price elasticities of
supply and demand are based on an Energy
28
Figure 2
Estimated Costs and Benefits of CO2 Abatement
1995 dollars per barrel of oil equivalent
50
40
30
20
10
Marginal benefit
High estimate
Low estimate
Marginal costÑworld
0 38 77 115 154 192 230 269 307 346 384 422 461 499 538 576
Risk-neutral
approach
Extreme
precautionary
approach
Reduce
emissions
3% below
1990 level
Reduce
emissions
to 1990 level Reduce emissions
7% below 1990 level
Millions of metric tons of carbon
Ð10
Modeling Forum study (1991) that compares
ten major world oil market models.6 Elasticities for other fuels are calibrated to estimates
adapted from Bohi (1981) and Brown and YŸcel
(1995).
Following Brown and Huntington (1998),
the responses for the region that encompasses
China, Eastern Europe, and the former Soviet
Union (C/EE/FSU) are judgmental. The production and consumption decisions in these countries are more likely to be influenced by the
forces of economic transition than by changes
in world energy prices. In fact, if the supply and
demand responses for the C/EE/FSU were made
comparable to responses for other country
groups, the conservation scenarios considered
here would reduce world energy prices enough
that the model would predict these economies
would import significant quantities of energy.
The author considers such a result untenable
and therefore assumes a smaller response to
price than for other countries. To the extent that
these countries are more sensitive in their response to price, the estimated costs of achieving
various world conservation targets without
cooperation from these countries would be
larger than reported here, but the thrust of the
current analysis would be unchanged.
The response of oil producers within OPEC
is highly uncertain. To date, formal modeling of
OPEC decisions has been far from reliable.
OPEC appears to operate like an imperfect cartel at some times but not at others. The OPEC
countries appear to be about as uncomfortable
with a rapidly increasing market share (such as
accompanied the relatively low prices of the
1960s) as they are with a rapidly decreasing
market share (such as occurred in the aftermath
of the price hikes of the late 1970s and early
1980s). The analysis presented here assumes
that OPEC acts to maintain a constant market
share.7
Cost estimates are obtained by computing
the welfare costs of policies under which the
United States works in concert with other countries in the Organization for Economic Cooperation and Development (OECD) to reduce global
CO2 emissions through fossil fuel conservation.
The modeling framework allows world energy
prices to adjust to the conservation of fossil
energy to restore a balance between supply and
demand conditions in each market. Analytically,
carbon taxes are used to reduce the consumption of fossil fuels in the two country groups.
The tax approach assumes that conservation
measures are applied across all end uses.
Values from these simulations are used
with equations in the appendix to construct
marginal cost curves for U.S. abatement of CO2
emissions. This methodology follows the welfare-theoretic approach previously employed by
Brown and Huntington (1994a, 1994b, 1998)
and Felder and Rutherford (1993). The resulting
cost curves take into account a number of
factors, including the direct welfare costs of
U.S. conservation efforts, transfers of wealth
FEDERAL RESERVE BANK OF DALLAS 29 ECONOMIC REVIEW FOURTH QUARTER 1998
Figure 3
Estimated Costs and Benefits of CO2 Abatement
1995 dollars per barrel of oil equivalent
50
40
30
20
10
0
Ð10
between countries, the effect lower energy
prices would have in stimulating energy consumption in nonparticipating countries, and the
economic cost of OPEC cartelization.8
Costs of Reducing CO2 Emissions
The first marginal cost curve, which is
labeled ÒMarginal costÑworld,Ó is shown in
Figure 2. This curve represents the marginal
costs to the world of the U.S. fossil fuel conservation necessary to reduce CO2 emissions. Economic well-being is maximized at the level of
CO2 abatement where the marginal cost equals
the marginal benefit. The risk-neutral approach
would be to equate marginal cost to the mean
estimate of marginal benefit. As shown in Figure
2, estimated marginal cost equals the mean estimate of marginal benefit at 65 metric tons of
CO2 abatement.
An extreme precautionary approach to
avoiding the risk of global warming suggests
using the upper bound estimate of the likely
range as the measure of marginal benefit. As
shown in Figure 2, marginal cost equals this
upper bound at just under 200 metric tons of
CO2 abatement.
In comparison, President ClintonÕs proposal to reduce U.S. emissions to 1990 levels
by 2010 implies 384 metric tons of CO2 abatement, a figure substantially higher than what
is optimal under either measure of marginal
benefit. At this level of CO2 abatement, the
marginal cost is more than $16 per barrel of
Marginal benefit
High estimate
Low estimate
Marginal costÑworld
0 38 77 115 154 192 230 269 307 346 384 422 461 499 538 576
Reduce
emissions
3% below
1990 level
Reduce
emissions
to 1990 level
Reduce emissions
7% below 1990 level
Millions of metric tons of carbon
Free lunch Marginal
costÑU.S.
oil equivalent, substantially more than the mean
estimate of marginal benefit of $2.86 per barrel
of oil equivalent or the likely upper bound estimate of $6.61 per barrel of oil equivalent.
Compliance with the Kyoto accord would
seem to imply 478 metric tons of CO2 abatement
in 2010 from fossil fuel conservation, at a marginal cost of nearly $25 per barrel of oil equivalent. U.S. officials expect to use offsets and
other credits, however, to reduce the burden
from conservation of fossil fuels to 3 percent
below 1990 levels. That implies 424 metric tons
of CO2 abatement from the conservation of fossil fuels, at a marginal cost of just under $20 per
barrel of oil equivalent.
Improved Terms of Trade
Because the United States imports oil and
natural gas, it can improve its terms of trade by
conserving those fuels. The improved terms of
trade mean that the United States incurs lower
costs for its actions to reduce CO2 emissions
than the world incurs from the U.S. actions. As
shown by the curve labeled ÒMarginal costÑ
U.S.Ó in Figure 3, the lower marginal cost
implies that a greater reduction in CO2 emissions is optimal.
Such a conclusion is flawed, however.
Optimality cannot be found by equating the
marginal benefit to the world to the marginal
cost to the United States. Sound analysis
requires consistency in defining the incidence of
costs and benefits.
30
Free Lunch: There Is No Such Thing
A number of energy analysts argue that
the United States can cut its energy consumption by 25 percent and achieve a cost savings at
the same time. As shown by the curve labeled
ÒFree lunchÓ in Figure 3, President ClintonÕs target for reducing CO2 emissions would be very
close to optimal if the free-lunch cost curve represented reality. In fact, some analysts who consider this cost curve accurate and also favor the
extreme precautionary approach to reducing
CO2 emissions have criticized the presidentÕs
target as too conservative. As shown in Figure 3,
achieving the target of reducing CO2 emissions
from fossil fuels 3 percent below 1990 levels
would have a marginal cost that is above the
mean estimate of marginal benefit but below
the likely upper bound.
Analysts who believe in the free lunch use
conceptually flawed studies to support their
claims. What these analysts are unable to explain is why a free market would leave such
cost savings on the table. Instead, they offer
vague explanations of market barriers, including
inappropriate lifestyle choices, and demand
government regulation to reduce what they see
as wasteful use of energy (see Brown 1996).
Hidden Costs of Policy
Economic policy often carries with it hidden costs that are not captured by traditional
welfare-theoretic measures. Regulatory inefficiency is one way in which costs can escalate.
Figure 4
Estimated Costs and Benefits of CO2 Abatement
1995 dollars per barrel of oil equivalent
140
120
100
80
60
40
20
0
FEDERAL RESERVE BANK OF DALLAS 31
When regulation is used instead of broad market incentives, such as taxes, the lowest cost
methods of energy conservation can be ignored.
Interference in free trade is another way
policies to reduce CO2 emissions can have hidden costs. Broad programs of energy conservation permit energy-importing countries to
improve their terms of trade with energy-
exporting countriesÑa fact that has not been
lost on OPEC. The countries that are the most
dependent on imported energy have been the
most aggressive in promoting global cooperation to reduce CO2 emissions. More self-sufficient countries, such as the United States, have
been more reluctant to participate. Within the
United States, energy conservation has a
decided tilt toward the conservation of oil, the
fuel for which we are most import-dependent.
Rent-seeking behavior is another way in
which policy can have hidden costs. Changes in
policy create winners and losers. Both groups
have an incentive to expend real resources
to achieve their objectives by influencing the
political process, which can add sizable costs to
policy.
Using an approach first suggested by
Tullock (1967), the author estimates the potential hidden costs of policy. As shown in Figure
4, these costs can be sizable. With the hidden
costs incorporated, the marginal cost of reducing U.S. CO2 emissions is more than $30 per
barrel of oil equivalent at zero abatement and
more than $80 at full compliance with the Kyoto
ECONOMIC REVIEW FOURTH QUARTER 1998
Marginal benefit
Marginal costÑworld
0 38 77 115 154 192 230 269 307 346 384 422 461 499 538 576
Millions of metric tons of carbon
Marginal cost, including hidden cost
Aggregate Economic Consequences for the United States
In terms of fore-Figure B.1
gone economic oppor-U.S. CO2 Abatement and GDP Losses
tunities, the energy
conservation associ-Percentage of GDP loss
ated with CO2 abate-0
ment can be seen as
equivalent to increas-Ð1
ing the price of
energy, which carries Ð2
with it the expectation
of slower economic Ð3
growth. Most econo
Ð4
mists agree that GDP
is a poor way to mea
Ð5
sure economic well
being, particularly Ð6
when evaluating envi
ronmental policy. Ð7
Nevertheless, slower
economic growth can
Low estimate
High estimate
Reduce emissions
to 1990 level
Reduce
emissions
3% below
1990 level
Reduce
emissions
7% below
1990 level
0 38 77 115 154 192 230 269 307 346 384 422 461 499 538 576
Millions of metric tons of carbon
result in significant
political pressure on fiscal and monetary authorities to offset the slowdown. Yielding
to that pressure could lead to higher inflation.
As shown in Figure B.1, the effect on aggregate economic activity depends
on the amount of CO2 abatement. The amount of energy conservation required to
reduce 2010 CO2 emissions to the 1990 level would imply that U.S. GDP would be
2.7 to 3.7 percent lower in 2010 than it would otherwise be.* Assuming the United
States could use offsets and credits, compliance with the Kyoto accord would imply
that U.S. GDP would be 3 to 4.3 percent lower in 2010. These estimates imply that if
the United States embarked on a ten-year program to achieve compliance with the
Kyoto accord, U.S. GDP growth would be 0.3 to 0.4 percent lower per year.
* GDP loss estimates are obtained through elasticities that relate energy prices to aggregate
economic activity. The elasticities were chosen to represent the range of estimates from a
number of prominent economic studies.
accord. If the potential for hidden costs were
taken seriously, the cost of reducing CO2 emissions would greatly outweigh its benefits.
CONCLUSIONS
Global warming is a theory partially supported by the facts. More evidence is needed to
definitively conclude that the rising atmospheric
level of CO2 resulting from the use of carbon-
based fuels is causing global warming. Nevertheless, most scientists who study the issue
think that the use of fossil fuels is contributing
at least some of the global warming that
appears to be occurring. Despite this seeming
consensus, there is considerable uncertainty
about both the magnitude and the environmental consequences of global warming.
Given these uncertainties, reducing CO2
emissions is like insurance against global warming and its possible environmental consequences. Under most current proposals, the
developed nations would buy all or most of the
insurance. Developing nations would be asked
to contribute once they attain higher levels of
income. CostÐbenefit analysis suggests that
reducing U.S. emissions of CO2 to comply with
the Kyoto accord or to reach the more modest
target proposed by President Clinton represents
too much insurance. Analysis for the other
OECD countries yields a similar result. It is not
surprising, therefore, that little headway has
been made in ratifying the accord.
NOTES
The author would like to thank Frank Berger, Sterling
Burnett, Mike Canes, Roger Hemminghaus, Hill
Huntington, Don Norman, Steve Prowse, Cece Smith,
Ron Sutherland, Lori Taylor, Mine YŸcel, and Carlos
Zarazaga for helpful comments and discussions without implicating them in the conclusions.
1
For a comprehensive treatment of emissions other than
CO2, see Hall (1990, 1992).
2
The Department of Energy projection that world CO2
emissions from fossil fuels would increase about 45
percent from 1990 to 2010 owes greatly to expectations of accelerating growth and industrialization in
developing areas of the world.
3
These estimates of damage are adapted from Brown
and Huntington (1998). Previous analysis suggests a
flat marginal damage curve. Summarizing the previous
literature, Peck and Teisberg (1992) explain that marginal damage costs are essentially unaffected by the
emissions levels in any given decade. This conclusion
rests on the finding that temperature change depends
on gas concentration, which is not greatly affected by
emissions levels in any given decade. I follow this
characterization by assuming horizontal damage
curves that depict a constant level of benefits for any
level of CO2 abatement.
4
The author developed the analytical framework with
Hillard G. Huntington of Stanford University.
5
The projected energy-demand conditions depend on a
variety of assumptions about economic growth and the
extent of energy-saving technological change in the
absence of price change. The supply conditions other
than OPEC oil production incorporate assumptions
about the resource base, engineering constraints on
developing resources, and producer-country taxes
and policies. In these projections, OPEC members
satisfy the excess demand but adjust the next periodÕs
price in response to market tightness.
6
See Huntington (1992, 1993).
7
Griffin (1985) and Dahl and YŸcel (1991) provide
empirical estimates of OPEC behavior that are broadly
consistent with this view.
8
My analysis abstracts from a number of considerations
featured in other studies of energy conservation. Hoel
(1991a) and Newberry (1992) consider the effects of
other taxes and redistributive policies. Bohm (1993);
Brown and Huntington (1994b); Eyckmans, Proost, and
Schokkaert (1993); Hoel (1991b and 1994); Manne
32
and Rutherford (1994); Welsch (1995); and Whalley
and Wigle (1991) consider alternative policies for dis
tributing conservation goals across countries and
gains from cooperation. Felder and Rutherford (1993)
and Pezzey (1992) allow for different types of goods.
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Appendix
Some Analytics of CO2 Abatement
A welfare-theoretic approach can be used to
derive formulas for the marginal cost of CO2 abatement achieved through the conservation of carbon-
based energy. For any country (or country grouping),
the economic welfare obtained from the market for
a particular source of energy is the sum of consumer and producer surpluses:
QDij
(.) A1 W = P (Q dQ
) - PQ
ij ˜ Dij j j ijDij
0
QSij
- P() .
+ PQ QdQ
ij Sij ˜ Sij j j
0
In the above equation, Wij denotes the economic
welfare country i obtains from the market for
energy source j, QDij the quantity of primary
energy j demanded in country i, PDij country iÕs
demand price for energy source j (the marketÕs
marginal valuation of consumption excluding externalities) at each quantity (Qj), Pij the market price
of energy source j in country i, QSij the quantity of
energy j produced in country i, and PSij the domestic supply price of energy source j in country i
(marginal cost of its oil production excluding externalities) at each quantity (Qj).
Cost of Gross CO2 Abatement
The most direct measure of the cost of reducing CO2 emissions is the welfare losses occurring
in the energy markets that result from altering
energy consumption to reduce emissions. Assuming no other distortions in domestic energy markets
and no significant international trade in nonfossil
energy, summing over the marginal effects of the
emissions reduction policy on each fossil energy
source yields the marginal cost of compliance for
country i :
(.) MCi =Œ
jn
=1
Ž
‘�
( Dij - PWj )
¦
¦
QECiji
+ QMij
¦
¦
PEWji
�
ž
œ .
A2 P
In the above equation, MCi denotes the gross marginal cost of reducing CO2 emissions through the
conservation of carbon energy sources, PWj the
world price of energy source j, QCij the quantity of
energy source j that is conserved (where ¦ QCij =
Ц QDij), QMij country iÕs imports of energy source j,
and Ei is the reduction in country iÕs emissions
under the policy whose costs are being estimated.
As Equation A.2 shows, the gross marginal cost of
reducing emissions is the difference between the
domestic and world prices of each carbon energy
source (PDij Ð Pij) weighted by the shares of each
fuel conserved for a one-unit reduction in CO2
emissions, minus (plus) the transfers obtained
(lost) by reducing the price of imported (exported)
carbon energy, noting that ¦ PWj /¦ Ei is negative.
Cost of Net CO2 Abatement
The net effect of the CO2 abatement actions
taken by a country or group of countries is the
quantity of their abatement minus the induced
(continued on next page)
34
Some Analytics of CO2 Abatement
(continued )
change in CO2 emissions in the rest of the world.
The change in CO2 emissions in nonparticipating
countries depends on how their consumption of
fossil energy is affected by a change in world
energy prices and how the conservation actions in
the participating countries affect the world oil price.
Therefore, the relationship between a change in
participant CO2 emissions and the net change in
world CO2 emissions can be expressed as
(.) ¦EW 1 Œ
n
Ej
¦QDXj ¥
¦PWj .
A3 =-
¦Ei j1 ¦PWj ¦Ei
=
In the above equation, EW denotes the amount by
which world CO2 emissions are reduced, Ej the
CO2 emissions associated with consuming one unit
of carbon energy j, and QDXj the quantity of carbon
energy j consumed by nonparticipating countries.
Following Felder and Rutherford (1993) and
Brown and Huntington (1994a, 1998), Equations
A.2 and A.3 can be combined to express the
marginal cost of the net world reduction in CO2
emissions for country (or country grouping) i.
Specifically, multiplying the marginal cost of the
gross reduction in CO2 emissions for country i by
the net change in world CO2 emissions resulting
from country i reducing its CO2 emissions yields
(. ) A4 MCWi =Œ
jn
=1‘�
Ž
(PDij -PWj )
¦
¦
QECiji
+QMi
¦
¦
PEWji žœ
�
n
¾¦QDXj ¦PWj š
¥ ��
1-Œ
j =1Ej ¦PWj
¥ ¦Ei
Ö¿
.
In the above equation, MCWi denotes the net marginal cost to country i of its actions to reduce world
CO2 emissions.
As Equation A.4 shows, the effect fossil
energy conservation has on the cost of energy imports and on nonparticipant consumption of carbon
energy are related through the effect conservation
has on the world prices for these fuels. As cooperative conservation lowers the world prices of fossil
energy, it reduces the cost of country iÕs energy
imports and increases nonparticipant fossil energy
consumption. If conservation has no effect on
world energy prices, however, the energy-importing
countries will not obtain terms-of-trade advantages,
and fossil energy consumption will not be stimulated in nonparticipating countries.
World Perspective
From the world perspective, the cost of reducing CO2 emissions through fossil energy conservation is the sum of costs borne by each country.
From this perspective, net transfers cancel to zero.
For every country or group of countries that obtains
transfers from reduced prices for carbon energy,
another country or group of countries yields an offsetting transfer, and Mij(¦ PWj /¦ Ei) is exactly offset.
Accounting for the offsetting transfers, as well
as the distortion in world oil markets resulting from
OPEC holding its oil production below free market
levels, alters Equation A.4 to yield
n
(. ) A5 MCWi =
Ž�
‘
Œ
j =1
¾��
(PDij -PWj )
¦
¦
QECiji
šÖ¿
¦Q �
¦ECi1
O1( W1 -CO1)œ
+ SP
i ž
-1¾¦EW š
¥ �Ö .
�¦Ei ¿
In the above equation, MCWi denotes the net marginal cost to the world of country i Õs actions to
reduce emissions, QCi1 the amount of oil conserved, SO1 OPECÕs share of world oil production,
and CO1 OPECÕs cost of oil production.
Hidden Costs
Tullock (1967) argues that economic agents
have the incentive to expend real resources to
influence economic policy up to the total value of
the transfers that might result from the policy. In
doing so they would dissipate the total value of the
potential transfers as costs. Incorporating these
hidden costs into the analysis alters Equation A.5
to yield
n
Ž¾ ¦(PDij -PWj )š
A6 MC =
(.) Hi �
‘
Œ
j =1
��
QDij ¦Ei
+¦QCi1 SP( -
¦Ei
O1W1
-1
¾¦EW š
¥ �Ö .
�¦Ei ¿
Ö
¿
�
CO1) œ
ž
In the above equation, MCHi denotes the net marginal cost to the world, inclusive of hidden costs, of
country iÕs actions to reduce emissions. Note that
QDij is the consumption of fuel j in country i.
FEDERAL RESERVE BANK OF DALLAS 35 ECONOMIC REVIEW FOURTH QUARTER 1998