The Climate Change Pact agreed by leaders at the end of COP26 in Glasgow went further than many pessimists had forecast, but not far enough to meet the goal of keeping global warming to 1.5°C above pre-industrial levels. The Pact states that:
limiting global warming to 1.5°C requires rapid, deep and sustained reductions in global greenhouse gas emissions, including reducing global carbon dioxide emissions by 45 per cent by 2030 relative to the 2010 level and to net zero around mid-century, as well as deep reductions in other greenhouse gases.
So how far would the commitments made in Glasgow restrict global warming and what actions need to be put in place to meet these commitments?
Short-term commitments and long-term goals
According to Climate Action Tracker, the short-term commitments to action that countries set out would cause global warming of 2.4°C by the end of the century, the effects of which would be calamitous in terms of rising sea levels and extreme weather.
However, long-term commitments to goals, as opposed to specific actions, if turned into specific actions to meet the goals would restrict warming to around 1.8°C by the end of the century. These long-term goals include reaching net zero emissions by certain dates. For the majority of the 136 countries agreeing to reach net zero, the date they set was 2050, but for some developing countries, it was later. China, Brazil, Indonesia, Russia, Nigeria, Sri Lanka and Saudi Arabia, for example, set a date of 2060 and India of 2070. Some countries set an earlier target and others, such as Benin, Bhutan, Cambodia, Guyana, Liberia and Madagascar, claimed they had already reached zero net emissions.
Despite these target dates, Climate Action Tracker argues that only 6 per cent of countries pledging net zero have robust policies in place to meet the targets. The problem is that actions are required by firms and individuals. They must cut their direct emissions and reduce the consumption of products whose production involved emissions.
Governments can incentivise individuals and firms through emissions and product taxes, through carbon pricing, through cap-and-trade schemes, through subsidies on green investment, production and consumption, through legal limits on emissions, through trying to change behaviour by education campaigns, and so on. In each case, the extent to which individuals and firms will respond is hard to predict. People may want to reduce global warming and yet be reluctant to change their own behaviour, seeing themselves as too insignificant to make any difference and blaming big business, governments or rich individuals. It is important, therefore, for governments to get incentive mechanisms right to achieve the stated targets.
Let us turn to some specific targets specified in the Climate Change Pact.
Phasing out fossil fuel subsidies
Paragraph 20 of the Climate Change Pact
Calls upon Parties to accelerate … efforts towards the … phase-out of inefficient fossil fuel subsidies, while providing targeted support to the poorest and most vulnerable in line with national circumstances and recognizing the need for support towards a just transition.
Production subsidies include tax breaks or direct payments that reduce the cost of producing coal, oil or gas. Consumption subsidies cut fuel prices for the end user, such as by fixing the price at the petrol pump below the market rate. They are often justified as a way of making energy cheaper for poorer people. In fact, they provide a bigger benefit to wealthier people, who are larger users of energy. A more efficient way of helping the poor would be through benefits or general tax relief. Removing consumption subsidies in 32 countries alone would, according to International Institute for Sustainable Development, cut greenhouse gas emission by an average of 6 per cent by 2025.
The chart shows the 15 countries providing the largest amount of support to fossil fuel industries in 2020 (in 2021 prices). The bars are in billions of dollars and the percentage of GDP is also given for each country. Subsidies include both production and consumption subsidies. (Click here for a PowerPoint of the chart.) In addition to the direct subsidies shown in the chart, there are the indirect costs of subsidies, including pollution, environmental destruction and the impact on the climate. According to the IMF, these amounted to $5.4 trillion in 2020.
But getting countries to agree on a path to cutting subsidies, when conditions vary enormously from one country to another, proved very difficult.
The first draft of the conference agreement called for countries to ‘to accelerate the phasing-out of coal and subsidies for fossil fuels’. But, after objections from major coal producing countries, such as China, India and Australia, this was weakened to calling on countries to accelerate the shift to clean energy systems ‘by scaling up the deployment of clean power generation and energy efficiency measures, including accelerating efforts towards the phasedown of unabated coal power and phase-out of inefficient fossil fuel subsidies’. (‘Unabated’ coal power refers to power generation with no carbon capture.) Changing ‘phasing-out’ to ‘the phasedown’ caused consternation among many delegates who saw this as a substantial weakening of the drive to end the use of coal.
Another problem is in defining ‘inefficient’ subsidies. Countries are likely to define them in a way that suits them.
The key question was the extent to which countries would actually adopt such measures and what the details would be. Would they be strong enough? This remained to be seen.
As an article in the journal, Nature, points out:
There are three main barriers to removing production subsidies … First, fossil-fuel companies are powerful political groups. Second, there are legitimate concerns about job losses in communities that have few alternative employment options. And third, people often worry that rising energy prices might depress economic growth or trigger inflation.
The other question with the phasing out of subsidies is how and how much would there be ‘targeted support to the poorest and most vulnerable in line with national circumstances’.
Financial support for developing countries
Transitioning to a low-carbon economy and investing in measures to protect people from rising sea levels, floods, droughts, fires, etc. costs money. With many developing countries facing serious financial problems, especially in the light of measures to support their economies and healthcare systems to mitigate the effects of COVID-19, support is needed from the developed world.
In the COP21 Paris Agreement in 2015, developed countries pledged $100 billion by 2020 to support mitigation of and adaptation to the effects of climate change by developing countries. But the target was not reached. The COP26 Pact urged ‘developed country Parties to fully deliver on the $100 billion goal urgently and through to 2025’. It also emphasised the importance of transparency in the implementation of their pledges. The proposal was also discussed to set up a trillion dollar per year fund from 2025, but no agreement was reached.
It remains to be seen just how much support will be given.
Then there was the question of compensating developing countries for the loss and damage which has already resulted from climate change. Large historical polluters, such as the USA, the UK and various EU countries, were unwilling to agree to a compensation mechanism, fearing that any recognition of culpability could make them open to lawsuits and demands for financial compensation.
- More than 100 countries at the meeting agreed to cut global methane emissions by at least 30 per cent from 2020 levels by 2030. Methane is a more powerful but shorter-living greenhouse gas than carbon. It is responsible for about a third of all human-generated global warming. China, India and Russia, however, did not sign up.
- Again, more than 100 countries agreed to stop deforestation by 2030. These countries include Indonesia and Brazil, which has been heavily criticised for allowing large parts of the Amazon rainforest to be cleared for farming, such that the Amazon region in recent years has been a net emitter of carbon from the felling and burning of trees. The pledge has been met with considerable cynicism, however, as it unclear how it will be policed. Much of the deforestation around the world is already illegal but goes ahead anyway.
- A mechanism for trading carbon credits was agreed. This allows countries which plant forests or build wind farms to earn credits. However, it may simply provide a mechanism for rich countries and businesses to keep emitting as usual by buying credits.
- Forty-five countries pledged to invest in green agricultural practices to make farming more sustainable.
- Twenty-two countries signed a declaration to create zero-emission maritime shipping routes.
- The USA and China signed a joint declaration promising to boost co-operation over the next decade on various climate actions, including reducing methane emissions, tackling deforestation and regulating decarbonisation.
Blah, blah, blah or real action?
Many of the decisions merely represent targets. What is essential is for countries clearly to spell out the mechanisms they will use for achieving them. So far there is too little detail. It was agreed, therefore, to reconvene in a year’s time at COP27 in Egypt. Countries will be expected to spell out in detail what actions they are taking to meet their emissions targets and other targets such as ending deforestation and reducing coal-fired generation.
- COP26 ended with the Glasgow Climate Pact. Here’s where it succeeded and failed
CNN, Angela Dewan and Amy Cassidy (14/11/21)
- Good COP, Bad COP: Separating heat from light at the climate summit
Ing, Samuel Abettan, Gerben Hieminga and Coco Zhang (15/11/21)
- COP26: What was agreed at the Glasgow climate conference?
BBC News (15/11/21)
- Five Things You Need to Know About The New Glasgow Climate Pact
The Conversation, Simon Lewis and Mark Maslin (13/11/21)
- Infographic: What has your country pledged at COP26?
Aljazeera, Hanna Duggal (14/11/21)
- Cop26: world on track for disastrous heating of more than 2.4C, says key report
The Guardian, Fiona Harvey (9/11/21)
- Cop26 took us one step closer to combating the climate crisis
The Guardian, Christiana Figueres (15/11/21)
- After the failure of Cop26, there’s only one last hope for our survival
The Guardian, George Monbiot (14/11/21)
- Why fossil fuel subsidies are so hard to kill
Nature, Jocelyn Timperley (20/10/21)
- The COP26 blah blah blah detector
Rappler, Elpidio Peria (16/11/21)
- What were the main achievements of COP26?
- What were the main failings of COP26?
- How can people be incentivised to reduce their direct and indirect greenhouse gas emissions?
- How is game theory relevant to understanding the difficulties in achieving global net zero emissions?
- Should developing countries be required to give up coal power?
- If the world is to achieve net zero greenhouse gas emissions, should all countries achieve net zero or should some countries achieve net negative emissions to allow others to continue with net positive emissions (albeit at a lower level)?
With the bounce-back from the pandemic, many countries have experienced supply-chain problems. For example, the shortage of lorry drivers in the UK and elsewhere (see the blog Why is there a driver shortage in the UK?) has led to empty shelves, fuel shortages and rising prices. The problem has been exacerbated by a lack of stock holding. Holding minimum stocks has been part of the modern system of ‘just-in-time’ (JIT) supply-chain management.
JIT involves involves highly integrated and sophisticated supply chains. Goods are delivered to factories, warehouses and shops as they are needed – just in time. Provided firms can be sure that they will get their deliveries on time, they can hold minimum stocks. This enables them to cut down on warehousing and its associated costs. The just-in-time approach to supply-chain management was developed in the 1950s in Japan and since the 1980s has been increasingly adopted around the world, helped more recently by sophisticated ordering and tracking software.
If supply chains become unreliable, however, JIT can lead to serious disruptions. A hold-up in one part of the chain will have a ripple effect along the whole chain because there is little or no slack in the system. When the large container ship, the Ever Given, en route from Malaysia to Felixtowe, was wedged in the Suez canal for six days in March this year, the blockage caused shipping to be backed up. By day six, 367 container ships were waiting to transit the canal. The disruption to supply cost some £730m.
JIT works well when sources of supply and logistics are reliable and when demand is predictable. The pandemic is causing many logistics and warehousing managers to consider building a degree of slack into their systems. This might involve companies having alternative suppliers they can call on, building in more spare capacity and having their own fleet of lorries or warehousing facilities that can be hired out when not needed but can be relied on at times of high demand.
When the ‘bounce back’ subsides, so may the current supply chain bottlenecks. But the rethinking that has been generated by the current problems may see new patterns emerge that make supply chains more flexible without becoming more expensive.
- What Is a Just-in-Time Supply Chain?
The Balance Small Business, Martin Murray (12/10/20)
- Why it’s high time to move on from ‘just-in-time’ supply chains
The Guardian, Kim Moody (11/10/21)
- Logistics Study Reveals Three Potential Cures To Global Supply Chain Problems
Forbes, Garth Friesen (20/9/21)
- Just-in-Time Manufacturing Needs Better Data
Supply & Demand Chain Executive, Paul Lachance (8/10/21)
- Just-in-time supply chains after the Covid-19 crisis
VoxEU, Frank Pisch (30/6/20)
- Plastics industry moves away from just-in-time logistics amid increased volatility
S&P Global, Miguel Cambeiro, Baoying Ng and George Griffiths (8/10/21)
- Just-in-time supply chains have left us dependent and with just-not-enough
CityAM, Tom Tugendhat MP (1/10/21)
- Supply chain havoc is getting worse — just in time for holiday shopping
Vox, Rebecca Heilweil (7/10/21)
- Ever Given and the Suez Canal: A list of affected ships and what delays mean for shippers
Supply Chain Dive, Matt Leonard (25/3/21)
- What are the costs and benefits of a just-in-time approach to logistics?
- Are current supply chain problems likely to be temporary or are there issues that are likely to persist?
- How might the JIT approach be reformed to make it more adaptable to supply chain disruptions?
Competition authorities across the globe have recently been paying close attention to the activity of large firms in high-tech markets, in particular Google, Amazon, Facebook and Apple. One estimate suggests that 30 cases have been opened by the authorities since 2010, and a third of these were launched in 2020.
One of the most prominent recent cases in the US courts concerns a complaint made by Epic Games, producer of the popular Fortnite game, against Apple. The background to the case is Apple’s standard practice on its App Store of taking a 30% cut of all paid app and in-app purchases. Therefore, a Fortnite player purchasing $10 worth of in-game currency would result in $7 for Epic and $3 for Apple.
However, in August 2020 Epic decided, contrary to Apple’s terms and conditions, to offer players an alternative way to purchase in-game currency. Gamers would see a choice screen giving them the option to buy currency through the Apple App Store or to buy it directly from Epic. Crucially, purchasing directly from Epic would be cheaper. For example, the same $10 worth of in-game currency on the App Store would cost only $8 if purchased directly from Epic.
It is clear to see why Epic was in favour of direct payments – it earns revenue of $8 instead of $7. However, note that the benefits for gamers are even larger – they save $2 by buying directly. In other words, Epic is passing on 2/3 of the cost saving to consumers.
Apple very quickly responded to Epic’s introduction of the direct purchase alternative by removing Fortnite from the App Store. Epic then filed a complaint with the US District Court.
The Epic v Apple court case
The case concerned Apple restricting game developers’ ability to promote purchasing mechanisms outside the App Store. However, more broadly, it also examined Apple’s complete control of the iOS app market since all apps must be distributed through the Apple App Store. Epic had previously disrupted PC games distribution by launching its own platform with lower fees. The setup of iOS and Apple’s actions against Epic make this an impossible way to reach users.
The Court’s analysis of the Epic v Apple case depended upon several key factors. First, the market definition. To be found to have breached competition law Apple must have a significant share of the market. If the market is defined as that for iOS apps, this is clearly the case. However, if, as Apple argues, it is broader, encompassing the options to play Epic games through web browsers, gaming consoles and PCs, then this is not the case.
Second, even if the market is narrowly defined, Apple argues that its control of the app distribution market is essential to provide user friendly and secure provision of apps. Furthermore, revenue extracted from app producers can enable more investment in the iOS. Without Apple controlling the market, app producers would be able to free-ride on the visibility the App Store provides for their apps.
The US Court announced its ruling on 10 September 2021. The judge decided that the market was broader than just iOS and thus Apple is not considered to be a monopolist. This has been touted as a major success for Apple, as it will allow the company to maintain its control of the app distribution market. However, the Court also ruled that Apple must allow game developers to link and direct users to alternative purchasing methods outside the App Store.
The Court’s decision in the Epic v Apple case closely follows concessions recently made by Apple for so called ‘reader apps’ such as Spotify and Netflix. Following an investigation by the Japanese authorities, these concessions allowed such apps to promote and receive purchases directly from consumers as long as they were made outside the app. These apps could be treated differently, as digital goods are consumed on multiple devices. However, the decision in the Epic case now extends such concessions to gaming apps.
It is unclear whether Apple will appeal the decision in the case Epic brought. If not, Apple stands to lose considerable revenue from its 30% share of in-app purchases. It will be very interesting to see how this ruling affects how Apple runs the App Store. Epic, on the other hand, has already made clear it will appeal the decision, aiming to prevent Apple gaining a share of any payment users make outside the app.
Matt Olczak and Jon Guest
- Why might a firm involved in a competition case, such as Apple, try to convince the authorities to define the relevant market as broadly as possible?
- Using the example of the Epic v Apple case, explain how Apple’s actions could be seen as both exclusionary and exploitative abuses of a dominant position.
With the coronavirus pandemic having reached almost every country in the world, the impact on the global economy has been catastrophic. Governments have struggled balancing the spread of the virus and keeping the economy afloat. This has left businesses counting the costs of various control measures and numerous lockdowns. The crisis has particularly affected small and medium-sized enterprises (SMEs), causing massive job losses and longer-term economic scars. Among these is an increase in the market power held by dominant firms as they emerge even stronger while smaller rivals fall away.
It is feared that with the full effects of the pandemic not yet realised, there may well be a wave of bankruptcies that will hit SMEs harder than larger firms, particularly in the most affected industries. Larger firms are most likely to be more profitable in general and more likely to have access to finance. Firm-level analysis using Orbis data, which includes listed and private firms, suggests that the pandemic-driven wave of bankruptcies will lead to increases in industry concentration and market power.
What is market power?
A firm holds a dominant position if its power enables it to operate within the market without taking account of the reaction of its competitors or of intermediate or final consumers. The key role of competition authorities around the world is to protect the public interest, particularly against firms abusing their dominant positions.
The UK’s competition authority, the Competition and Markets Authority (CMA) states:
Market power arises where an undertaking does not face effective competitive pressure. …Market power is not absolute but is a matter of degree; the degree of power will depend on the circumstances of each case. Market power can be thought of as the ability profitably to sustain prices above competitive levels or restrict output or quality below competitive levels. An undertaking with market power might also have the ability and incentive to harm the process of competition in other ways; for example, by weakening existing competition, raising entry barriers, or slowing innovation.
It can be hard to distinguish between a rapidly growing business and growing concentration of market power. In a pandemic, these distinctions can become even more difficult to discern, since there really is a deep need for a rapid deployment of capital, often in distressed situations. It is also not always evident whether the attempt to grow is driven by the need for more productive capacity, or by the desire to engage in financial engineering or to acquire market power.
It may be the case that, as consumers, we simply have no choice but to depend on various monopolies in a crisis, hoping that they operate in the public interest or that the competition authorities will ensure that they do so. With Covid-19 for example, economies will have entered the pandemic with their existing institutions, and therefore the only way to operate may be through channels controlled by concentrated power. Market dominance can occur for what seem to be good, or least necessary, reasons.
Why is market power a problem?
Why is it necessarily a problem if a successful company grows bigger than its competitors through hard work, smart strategies, and better technology adoption? It is important to recognise that increases in market power do not always mean an abuse of that market power. Just because a company may dominate the market, it does not mean there is a guaranteed negative impact on the consumer or industry. There are many advantages to a monopoly firm and, therefore, it can be argued that the existence of a market monopoly in itself should not be a cause of concern for the regulator. Unless there is evidence of past misconduct of dominance, which is abusive for the market and its stakeholders, some would argue that there is no justification for any involvement by regulators at all.
However, research by the International Monetary Fund concluded that excessive market power in the hands of a few firms can be a drag on medium-term growth, stifling innovation and holding back investment. Given the severity of the economic impact of the pandemic, such an outcome could undermine the recovery efforts by governments. It could also prevent new and emerging firms entering the market at a time when dynamism is desperately needed.
The ONS defines business dynamism as follows:
Business dynamism relates to measures of birth, growth and decline of businesses and its impact on employment. A steady rate of business creation and closure is necessary for an economy to grow in the long-run because it allows new ideas to flourish.
A lack of business dynamism could lead to a stagnation in productivity and wage growth. It also affects employment through changes in job creation and destruction. In this context, the UK’s most recent unemployment rate was 5%. This is the highest figure for five years and is predicted to rise to 6.5% by the end of 2021. Across multiple industries, there is now a trend of falling business dynamism with small businesses failing to break out of their local markets and start-up companies whose prices are undercut by a big rival. This creates missed opportunities in terms of growth, job creation, and rising incomes.
There has been a rise in mergers and acquisitions, especially amongst dominant firms, which is contributing to these trends. Again, it is important to recognise that mergers and acquisitions are not in themselves a problem; they can yield cost savings and produce better products. However, they can also weaken incentives for innovation and strengthen a firm’s ability to charge higher prices. Analysis shows that mergers and acquisitions by dominant firms contribute to an industry-wide decline in business dynamism.
Changes in market power due to the pandemic
The IMF identifies key indicators for market power, such as the percentage mark-up of prices over marginal cost, and the concentration of revenues among the four biggest players in a sector. New research shows that these key indicators of market power are on the rise. It is estimated that due to the pandemic, this increase in market dominance could now increase in advanced economies by at least as much as it did in the fifteen years to the end of 2015.
Global price mark-ups have risen by more than 30%, on average, across listed firms in advanced economies since 1980. And in the past 20 years, mark-up increases in the digital sector have been twice as steep as economy-wide increases. Increases in market power across multiple industries caused by the pandemic would exacerbate a trend that goes back over four decades.
It could be argued that firms enjoying this increase in market share and strong profits is just the reward for their growth. Such success if often a result of innovation, efficiency, and improved services. However, there are growing signs in many industries that market power is becoming entrenched amid an absence of strong competitors for dominant firms. It is estimated that companies with the highest mark-ups in a given year, have an almost 85 percent chance of remaining a high mark-up firm the following year. According to experts, some of these businesses have created entry barriers – regulatory or technology driven – which are incredibly high.
Professor Jayant R. Varma, a member of the MPC of the Reserve Bank of India (RBI), observed that in several sectors characterised by an oligopolistic core and a competitive periphery, the oligopolistic core has weathered the pandemic and it is the competitive periphery that has been debilitated. Rising profits and profit margins, improving capacity utilisation and lack of new capacity additions create ripe conditions for the oligopolistic core to start exercising pricing power.
The drivers and macroeconomic implications of such rises in market power are likely to differ across economies and individual industries. Even in those industries that benefited from the crisis, such as the digital sector, dominant players are among the biggest winners. The technology industry has been under the microscope in recent years, and increasingly the big tech firms are under scrutiny from regulators around the world. The market disruptors that displaced incumbents two decades ago have become increasingly dominant players that do not face the same competitive pressures from today’s would-be disruptors. The pandemic is adding to powerful underlying forces such as network effects and economies of scale and scope.
A new regulator that aims to curb this increasing dominance of the tech giants has been established in the UK. The Digital Markets Unit (DMU) will be based inside the Competition and Markets Authority. The DMU will first look to create new codes of conduct for companies such as Facebook and Google and their relationship with content providers and advertisers. Business Secretary Kwasi Kwarteng said the regime will be ‘unashamedly pro-competition’.
The additions in regulation in the UK fall in line with the guidance from the IMF. It recommends that adjustments to competition-policy frameworks need to be made in order to minimise the adverse effects of market dominance. Such adjustments must, however, be tailored to national circumstances, both in general and to address the specific challenges raised by the surge of the digital economy.
It recommends the following five actions:
- Competition authorities should be increasingly vigilant when enforcing merger control. The criteria for competition authorities to review a deal should cover all relevant cases – including acquisitions of small players that may grow to compete with dominant firms.
- Second, competition authorities should more actively enforce prohibitions on the abuse of dominant positions and make greater use of market investigations to uncover harmful behaviour without any reported breach of the law.
- Greater efforts are needed to ensure competition in input markets, including labour markets.
- Competition authorities should be empowered to keep pace with the digital economy, where the rise of big data and artificial intelligence is multiplying incumbent firms’ advantage. Facilitating data portability and interoperability of systems can make it easier for new firms to compete with established players.
- Investments may be needed to further boost sector-specific expertise amid rapid technological change.
The crisis has had a significant impact on all businesses, with many shutting their doors for good. However, there has been a greater negative impact on SMEs. Even in industries that have flourished from the pandemic, it is the dominant firms that have emerged the biggest winners. There is concern that the increasing market power will remain embedded in many economies, stifling future competition and economic growth. While the negative effects of increased market power have been moderate so far, the findings suggest that competition authorities should be increasingly vigilant to ensure that these effects do not become more harmful in the future.
Reviews of competition policy frameworks have already begun in some major economies. Young, high-growth firms that innovate and create high-quality jobs deserve a level playing field and a fair chance to succeed. Support directed to SMEs is important, as many small firms have been unable to benefit from government programmes designed to help firms access financing during the pandemic. Policymakers should act now to prevent a further, sharp rise in market power that could hold back the post-pandemic recovery.
- What are the arguments for and against the assistance of a monopoly?
- What barriers to entry may exist that prevent small firms from entering an industry?
- What policies can be implemented to limit market power?
- Define and explain market dynamism.
Economists are often criticised for making inaccurate forecasts and for making false assumptions. Their analysis is frequently dismissed by politicians when it contradicts their own views.
But is this fair? Have economists responded to the realities of the global economy and to the behaviour of people, firms, institutions and government as they respond to economic circumstances? The answer is a qualified yes.
Behavioural economics is increasingly challenging the simple assumption that people are ‘rational’, in the sense that they maximise their self interest by weighing up the marginal costs and benefits of alternatives open to them. And macroeconomic models are evolving to take account of a range of drivers of global growth and the business cycle.
The linked article and podcast below look at the views of 2019 Nobel Prize-winning economist Esther Duflo. She has challenged some of the traditional assumptions of economics about the nature of rationality and what motivates people. But her work is still very much in the tradition of economists. She examines evidence and sees how people respond to incentives and then derives policy implications from the analysis.
Take the case of the mobility of labour. She examines why people who lose their jobs may not always move to a new one if it’s in a different town. Partly this is for financial reasons – moving is costly and housing may be more expensive where the new job is located. Partly, however, it is for reasons of identity. Many people are attached to where they currently live. They may be reluctant to leave family and friends and familiar surroundings and hope that a new job will turn up – even if it means a cut in wages. This is not irrational; it just means that people are driven by more than simply wages.
Duflo is doing what economists typically do – examining behaviour in the light of evidence. In her case, she is revisiting the concept of rationality to take account of evidence on what motivates people and the way they behave.
In the light of workers’ motivation, she considers the implications for the gains from trade. Is free trade policy necessarily desirable if people lose their jobs because of cheap imports from China and other developing countries where labour costs are low?
The answer is not a clear yes or no, as import-competing industries are only part of the story. If protectionist policies are pursued, other countries may retaliate with protectionist policies themselves. In such cases, people working in the export sector may lose their jobs.
She also looks at how people may respond to a rise or cut in tax rates. Again the answer is not clear cut and an examination of empirical evidence is necessary to devise appropriate policy. Not only is there an income and substitution effect from tax changes, but people are motivated to work by factors other than take-home pay. Likewise, firms are encouraged to invest by factors other than the simple post-tax profitability of investment.
- In traditional ‘neoclassical’ economics, what is meant by ‘rationality’ in terms of (a) consumer behaviour; (b) producer behaviour?
- How might the concept of rationality be expanded to take into account a whole range of factors other than the direct costs and benefits of a decision?
- What is meant by bounded rationality?
- What would be the effect on workers’ willingness to work more or fewer hours as a result of a cut in the marginal income tax rate if (a) the income effect was greater than the substitution effect; (b) the substitution effect was greater than the income effect? Would your answers to (a) and (b) be the opposite in the case of a rise in the marginal income tax rate?
- Give some arguments that you consider to be legitimate for imposing controls on imports in (a) the short run; (b) the long run. How might you counter these arguments from a free-trade perspective?