Making things even worse

One of the most powerful concepts I’ve learnt about in environmental economics is known as “the theory of second best”. It’s one of those concepts that’s completely obvious to everyone except economists.

What it says is that in an economic system that’s pervaded by inefficiencies, fixing one source of inefficiency may actually make the system as a whole even more inefficient. In other words, in the real world - where the simplifying assumptions of economists don’t necessarily hold – taking the standard advice of Treasury boffins and other economic policy-makers and instituting microeconomic reform in one industry can actually make everything worse. I think the “second best” comes from the idea that it’s not a perfect world – and a second best world may require second best solutions.

An example is water trading. A big problem with rural water entitlements, say economists, is that traditionally they haven’t been able to be traded. Once you allow trading, the entitlements have a value, because you can sell them. This gives you an incentive to conserve as much water as you can, because you can sell any you don’t use. It also ensures that the water goes to its most highly valued use. The very profitable vineyard or, say, cotton farm that didn’t have enough water to expand can now buy that water from, say, the sheep farmer who was using it to grow grass in a very unprofitable paddock. The vineyard makes more money with its new water, the farmer makes more money because it’s more profitable to sell his water than use it for sheep, and we conserve more water overall. Hey presto, we’re all better off.

The trouble is, there’s all sorts of wacky goings on in the real world that complicate things. The most notable in this context is that there’s a whole lot of water entitlements that were given out years ago that farmers don’t use – because they don’t need them or because, for example, it’s more expensive to pump the water up from the river than it’s worth to the farm. These dormant entitlements are often called ‘sleeper licences’.

If you allow trading and there’s lots of sleeper licences around (which, in Australia, there are), what happens? Well, these licences suddenly have a value, and they’re not being used, so the farmers sell them. Others buy them and use them. Suddenly, a whole lot more water is being extracted from the rivers than before. Creeks dry up, the water doesn’t get to downstream users at all, salinity problems increase, the environment loses. Hey presto, we’re all worse off.

All pretty obvious, but just another reason why we need to be careful before we adopt economists’ magical market solutions. And this isn’t to defame economists too much either – they realise this stuff too and that’s why when water trading has been established recently in several Australian states, it’s been complicated and it’s been done slowly and carefully. It still hasn’t always worked.

Next post: A particularly horrific example of the theory of second best: European efforts to stop global warming devastate forests in developing countries.