The Undercover Economist Part 3

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So: if the right things are being made right in the right quan-t.i.ties and going to the people who value them most, there is no room for any gains in efficiency. To put it another way, you can't get more efficient than a perfectly compet.i.tive market. And it all fol-lows perfectly naturally from the truth contained in the price system: prices are true representations of cost to firms, and also true representations of value to customers.

Life without markets Because Western society relies heavily on free markets, we find it difficult to imagine what it would be like if we didn't, or to take a step back and see quite how profound the effect of the market is. Yet any modern democracy provides goods outside the mar-ket system, and looking at the way such goods are provided gives us a hint of the strengths and weaknesses of markets. Think of your friendly local police force, which is paid for by a nonmarket system of taxation. The nonmarket system has some advantages- for one thing, when you dial 911 n.o.body asks for your credit card details. The government is supposed to afford the same level of protection to the rich and poor, although it does not always seem that way.

But the nonmarket system also has some disadvantages. For instance, if a police officer is rude or incompetent, you don't have the option to shop for a different police force. If you think that the level of police protection you receive is excessive, it's not up to you to cut back a bit. Neither can you spend more if you de-cide that you'd like extra service. No, you have to lobby your local politicians and hope they consider your demands.

Government-provided schooling is another example of a nonmarket service that many of us use. In both Britain and the United States, most people send their children to government-funded schools. But those schools are different from each other- different atmospheres, different academic emphases. Most importantly, some are good schools, and some are not. The mar-ket solution for schools is similar to the market solution for food: the best food goes to the people who are willing-which also implies able-to pay most for it. But within the government sec-tor there are no prices. What happens instead? Parents line up, haggle, and protest. They move to districts with better schools. In Britain, government-run religious schools often have the best academic records, so atheists take their children to church every Sunday in order to get good references from priests and get their children into these schools.

As with the police, the nonmarket system has the cozy advan-tage of concealing the fact that the poor don't get the same qual-ity of education that the rich do. But again, the nonmarket system suffers from a serious problem: the truth about values, costs, and benefits has disappeared. It is impossible to tell which parents enroll their children in church schools for religious reasons and which parents are just looking for better results. It is also impos-sible to know how much parents would be willing to pay for more teachers and better materials. In a market system the truth would emerge about how much it costs to provide good schools, and who would be willing to pay for them. The nonmarket system struggles with these basic questions.

It seems that there is a willingness to pay for good schools, and we see it emerge because house prices are higher in the areas of schools with the best reputation. The nonmarket system, which gives preference to local children, channels the money that parents are willing to pay for a good school into the hands of property owners near existing good schools. This hardly seems sensible. A market system would simply direct the money to pay for more good schools.

The signaling function of prices Prices perform two functions, not just one. In a market system, prices provide a way of deciding who gets to enjoy a limited supply of schools: whoever pays most gets to send their children to the best schools, an uncomfortable state of affairs, which the government-school system is designed to prevent. But prices also give the sig-nal to build more schools, hire more teachers or raise their wages if they're in short supply, and buy better materials. In the longer term, a price system will transform a high willingness to pay for good schools into a lot of good schools, just as surely as it will transform a high demand for coffee into a lot of cappuccino.

Don't politicians know that we value good schools already? Should they be making government money available? The diffi-culty is that politicians hear that we want good schools, but they also hear that we want more police on the streets, a better health service, lots of big roads, excellent welfare benefits, low taxes, and a double-shot caramel Venti latte. It's easy for us to demand all of these things, but prices, by forcing us to put money where our mouths are, uncover the truth. Taxes have their advantages, but many don't contribute to truth because we cannot choose whether or not to pay them, depending on whether each penny is spent according to our wishes. Because prices are optional, they reveal information.

None of this amounts to a knockdown argument against pro-viding a police service or a school system with a nonmarket pro-cess. Nonmarket systems have their advantages, but they also lose something important: information, information about wants, needs, and desires, and about inconveniences and costs. Some-times the loss of information is worthwhile because it is offset by gains in equality or stability. But sometimes the loss of informa-tion can leave an economy, and a society, floundering in waste and confusion. We think that the value we get from schools and police are more than what they cost us in taxes, but we don't know for sure. Not so with the cappuccino.

Efficiency versus fairness: Can we handle the truth?

A perfectly compet.i.tive market is like a giant supercomputer network. With amazing processing power and sensors in every part of the economy-reaching even inside our brains to read our desires-the market is constantly reoptimizing production and allocating the results perfectly. Remember that when economists say the economy is inefficient, they mean that there's a way to make somebody better off without harming anybody else. While the perfectly compet.i.tive market is perfectly efficient, efficiency is not enough to ensure a fair society, or even a society in which we would want to live. After all, it is efficient if Bill Gates has all the money and everybody else starves to death . . . because there is no way to make anybody better off without making Bill Gates worse off. We need something more than efficiency.

So it's hardly surprising we sometimes prefer the cozy white lies: it is expensive, for example, to heat the house of an elderly lady in Minnesota, but we may prefer to subsidize the fuel, not wanting her to face the truth of that expense.

Even more than subsidies, taxes are a common cause of inefficiency: the government taxes market transactions and spends the money on, we hope, good things like police forces and schools. Why are taxes inefficient? Because they destroy the information carried by prices in perfectly compet.i.tive, efficient markets: price no longer equals cost, so cost no longer equals value. For example, a sales tax of 10 percent creates a "lie" in the following circ.u.mstances: Cost of cappuccino: ninety cents

Price of cappuccino in perfectly compet.i.tive market: ninety cents

Price of cappuccino after tax: ninety-nine cents

Willingness to pay for cappuccino: ninety-five cents

Cappuccino sold: none

Tax raised: zero There was a sale that could have created five cents of efficiency gains (cappuccino cost ninety cents but was valued at ninety-five cents) but which never happened because of the tax. What's worse, the tax wasn't even paid. If the government were able to waive the tax in such circ.u.mstances, they would be no worse off, but the coffee buyer would be better off: a clear efficiency gain. It's hard for tax officials to know when to charge the tax (situ-ations where taxes will not change buyers' behavior) and when to waive the tax (because potential buyers would have avoided it anyway, by not buying coffee ). But they try to do so using the kind of price-targeting strategies outlined in chapter 2. Taxes are often higher when price-sensitivity is low. For example, the govern-ment charges high taxes on gasoline and cigarettes, not for envi-ronmental and health reasons but because people who buy these products need to drive and are addicted to smoking; they won't change their behavior much even in the face of large taxes. We are faced with a dilemma. We want to avoid inefficiency, because that would leave us pa.s.sing up an opportunity to make somebody better off at no cost to anyone else. But taxes cause inefficiency, and most of us think we need taxes to redistribute income (to a greater or lesser extent) from the rich to the poor. We seem to be facing two contradictory imperatives: avoid the needless waste that is "inefficiency," but make sure that wealth is at least somewhat evenly spread. What we need is a way to make our economies both efficient and fair.

Can we enlist markets to help with fairness?

Is it true that we have to choose between the efficiency of perfect markets and the fairness of benevolent government intervention? This seemed to be the conclusion of governments throughout the free world after the experience of the Great Depression and World War II. President Roosevelt's "New Deal" programs of the 1930s expanded the role of the United States govern-ment, in response to the Great Depression. In Britain, Clem-ent Atlee's postwar government took control of much of the health, steel, air travel, petroleum, rail travel, and telephone industries. Government-owned businesses took over partly be-cause in the deprived, exhausted yet hopeful years after the war, economists had some confidence in the experts who had master-minded the war effort and thought they might not do a bad job of organizing the economy efficiently. Few people foresaw the later collapse of government-run economies, whether vast like the Soviet Union and China, or small like Tanzania or North Korea. But even if they had believed that private markets were more efficient, this was neither here nor there in the 1940s: the postwar Labour government in Britain would have been content to live with some inefficiency if it meant a fairer society.

But the old dilemma between efficiency and fairness was about to be shattered by a young New Yorker called Kenneth Arrow, who knew all about unfairness after watching helplessly as a teen-ager while his father lost his successful business and all his savings in the Great Depression. The desire for social justice stayed with Arrow, but intellectually he couldn't just ignore the question of efficiency. The young economist set his logical mind to wrestling with the tension between the unerring efficiency of the free mar-ket and the imperative that some kind of fairness should prevail. His solution was brilliant, twisting the traditional thinking about compet.i.tive markets and efficiency on its head. He proved that not only are all perfect markets efficient, all efficient outcomes can be achieved using a compet.i.tive market, by adjusting the starting position. Arrow went on to win every plaudit available to an economist, and he remains the youngest man ever to win the n.o.bel Prize for Eco-nomics. But why was his insight so important?

I call it the "head start theorem." Instead of focusing on the enormous complexity of a real economy, think of a very simple one-dimensional human challenge: the 100-meter sprint. The fastest sprinter will win the race. If you wanted all the sprinters to cross the line together, you could just change the rules of the race, ordering the fast runners to slow down and everyone to hold hands as they crossed the line. A waste of talent. Or you could move some starting blocks forward and some starting blocks back, so that although each sprinter was running as fast as he could, obeying the usual rules and objectives of sprinting, the fastest had to cover enough extra ground that he would end up breaking the tape neck-and-neck with the slowest.

Arrow demonstrated that the same approach could work when trying to balance the excesses of compet.i.tive markets: instead of interfering with the markets themselves, the trick is to adjust the starting blocks by making lump-sum payments and levying onetime taxes.

An example of a lump-sum tax would be the government tax-ing everybody eight hundred dollars; or alternatively, taxing everyone over the age of sixty-five eight hundred dollars; or al-ternatively, taxing everybody whose surname on the birth cer-tificate starts with H eight hundred dollars. The point is that unlike an income tax or a sales tax on coffee, a lump-sum tax doesn't affect anybody's behavior, because there is nothing you can do to avoid it. So unlike sales tax, it doesn't lead to an effi-ciency loss. Similarly, an example of lump-sum redistribution would be to give eight hundred dollars to everybody whose name starts with H, a policy for which I would be happy to vote.

In the 100-meter sprint, lump-sum taxation is like moving the starting blocks back a few paces. Income tax and sales tax are like asking the best runners to run backwards. Both would have the effect of ensuring a more equal finish, but moving the starting blocks around doesn't slow anybody down.

In the context of a sprint, it's fairly obvious that one of the ways to get a close result is to give the slower runners a head start. In the context of an economy, with literally billions of dif-ferent goods, desires, raw materials, and talents, the head start theorem is a much bolder claim. But it's true: you can allow the compet.i.tive economy to use every skill and every raw material, take advantage of every opportunity to trade, cooperate, educate, or invest . . . but still get a fair outcome by moving around the starting blocks and letting perfect markets do the rest.

The implication is that in a world of perfect markets, the only thing needed to ensure both fairness and efficiency is a "head start" strategy: a program of appropriate lump-sum taxes and subsidies that puts everyone on equal footing. The perfect mar-kets then find every possible opportunity to make everybody bet-ter off from their revised starting points. The question is, can this be done in practice?

Impractical examples Let's take an example. American political philosopher Robert Nozick deployed a famous argument against taking a view of "jus-tice as fairness." In other words, he disputed the notion that one particular allocation of wealth could be deemed the "best" or "fair" allocation. Nozick's argument invokes Wilt Chamberlain, a bas-ketball star famous in the 1960s and '70s, when Nozick was writ-ing. Chamberlain's talents made him wealthy; Nozick felt this was "just" because Chamberlain's wealth was the outcome of le-gitimate decisions by fans happy to pay to see him play. The situ-ation may have been "just" in Nozick's sense of the word, but can any situation that leads to a highly unequal distribution of cash be considered "fair"?

Perhaps taxing Chamberlain's income heavily would make the situation fairer, but Nozick warns that if Chamberlain did not re-ally enjoy playing basketball and he was loaded down with heavy taxes, he might stop playing altogether. So although this situation might seem more "fair," there would be neither the tax revenue, nor the basketball game: the problem of the cappuccino sales tax all over again. So how is it reasonable to call a distribution of in-come "fair" when everybody concerned, both fans and player, would prefer the "unfair" outcome?

Thanks to Kenneth Arrow, we now know that, when faced with a modern-day sports star like Tiger Woods, the solution is to levy a one-time lump-sum tax of several million dollars on him. He would still have the incentive to earn money by playing golf, since he could not avoid the tax by playing less, as he would have to do in order to avoid a heavy income tax. He would no doubt earn enough to pay off the tax bill and still retain enough to buy a family car and a nice house somewhere una.s.suming. In this scenario, there is no waste or inefficiency, but the result is "fair" in that it produces a much more even allocation of wealth.

The only trouble with this plan is that it's wildly impractical. The problem is not that it's impossible to have taxes that only apply to one individual: President Franklin Roosevelt introduced an income tax rate of 79 percent, but the threshold was so high that the tax was paid by only John D. Rockefeller. Rather, the problem is more that a true lump-sum tax isn't supposed to change behavior at all. Ideally it would have been decided before Tiger Woods was born, because if he could have predicted that he would be liable for a tax as a result of his success he might have chosen a different profession.

This is, of course, quite impossible. But we shouldn't abandon the head start theorem quite yet. While we can't always use lump-sum taxation and redistribution, we can sometimes: and when we can, it's worth considering because it preserves the efficiency and the truth of the compet.i.tive market while adding a welcome dose of fairness.

A practical example A more practical application of the head start theorem could be used to prevent elderly people from getting cold in winter, with-out damaging the environment. In a typical winter in Britain twenty-five thousand seniors die as a result of inadequate heat-ing. To address this concern, domestic fuel is subject to lower taxes than many other things. But that's a slightly odd way to deal with the problem-an equivalent to the "running backwards" solution. If governments need to raise tax revenue-and all of them do, it seems-then a first approximation of an efficient strat-egy would be to have the same sales tax on everything, because that wouldn't distort people's buying decisions too much. A more refined view would recall the "price-targeting" of chapter 2. Be-cause customers cannot easily cut down on fuel consumption, they are not very sensitive to the price of domestic fuel, hence the government should levy a bit more tax on fuel and a bit less on other goods: customers would not change their behavior much and so the inefficiency would be small. An even more sophisti-cated view (perhaps acquired from a peek ahead at chapter 4) would note that domestic fuel is a nonrenewable resource and using it causes pollution, so the case for higher tax on domestic fuel becomes even stronger.

The case for lower taxes on domestic fuel and higher taxes on other goods is hard to understand, until we start to worry about the elderly shivering in front of a lifeless gas or oil furnace that they cannot afford to switch on. Is this just one of those hard choices that governments sometimes have to make? Not neces-sarily. Instead of levying the wrong rate of tax on everyone else, better to choose a more sensible rate but give the elderly a head start-because of their poverty and because, being frail, they have an additional need for heating. The simple policy remedy is to raise fuel tax but give extra money to the elderly, money that they could use to switch that furnace on and stay warm.

We know from the head start theorem that given the money, pensioners will find their way to the efficient outcome-which, incidentally, may not involve more fuel being burned. Not every pensioner feels cold, and those who do may find better solutions to the problem. Some may use the money to move to Florida. Some may insulate their homes. Those who did not feel the cold in the first place can spend the money on other things. n.o.body will burn extra fuel unless they need to, and if they need to they'll have the money to meet that need.

The lesson of the head start theorem is that when a problem arises, it's worth asking whether the problem can be addressed by rearranging the starting blocks rather than interfering with the race. This strategy isn't always practical, but because free markets are efficient, it's worth trying to harness that efficiency to meet other goals.

Throughout this chapter, we've been on a flight of fantasy no more plausible than the story of Fletcher Reed. The "world of truth" is a world where markets are complete, free, and competi-tive. In reality we're about as likely to achieve a world with com-plete, free, and compet.i.tive markets as hotshot lawyers are to start telling the truth to everyone.

You might therefore be asking yourself why you've read a chapter, even a brief one, about some bizarre economists' fantasy. The answer is that the fantasy helps us understand why economic problems arise and also helps us to move in the right direction. We know that a world of perfect markets combined with the head start approach is as good as we're going to get. When real world economies malfunction, we know to look for the market failures-and to do our best to patch them up.

We've already explored one of those failures: some companies have scarcity power and can set prices that are far above their true cost, which is where they would be in a compet.i.tive market. This is why economists believe there's an important difference between being in favor of markets and being in favor of business, especially particular businesses. A politician who is in favor of markets believes in the importance of compet.i.tion and wants to prevent businesses from getting too much scarcity power. A poli-tician who's too influenced by corporate lobbyists will do exactly the reverse.

Whether abetted by politicians or otherwise, companies with scarcity power are one market failure. There are two others. In the next two chapters, we'll encounter them, leaving the curious world of truth behind us and facing up to the real world once again.


Crosstown Traffic

We've just learned that in the world of perfect markets, everything is for the best. We know that perfect markets are completely efficient, delivering outcomes that are flawless in every respect except distribution. We also know from the head start theorem that we can fix any complaints about distribution in advance. Presto, every problem solved, or at least every problem concerning the allocation of goods and services.

That's nice to hear, but then why did I spend two hours stuck in traffic on the way to work this morning? The b.u.mper-to-b.u.mper traffic was a stupid waste. All of us could have been riding buses, or carpooling, and we would have reached our destina-tions in downtown DC in fifteen minutes. Where is the perfect market there? The obvious answer is that, of course, there is no market perfect or otherwise for driving around on the streets. What may be less obvious is that there could be.

Economies that work smoothly because they are full of perfect markets are neither interesting nor realistic. But because perfect markets provide such a clear benchmark, economists find it much easier to start from them and work out what is going wrong, rather than start from scratch and work out what is going right. And this method of thinking about the world will lead us to the cure for crosstown traffic.

What's wrong with my world I am a happy man, but there are things in my life that infuriate me and that I wish could be different. I wish I didn't have to upgrade my computer software every couple of years at great expense. I wish that I could rely on my doctors to give me appropriate medical treatment when I am ill. I wish Washing-ton's streets were not clogged with traffic and filled with pollution.

These three personal, if common, grumbles correspond to the three key ways in which markets fail to live up to chapter 3's lofty ideals of perfection. Markets fail to work well in the face of scar-city power, as we saw in chapter 2. That is one of the problems with buying computer software-the market is dominated by a single company, Microsoft, which has tremendous power to set high prices. Markets also fail to work well if some decision mak-ers lack information. When I go to my doctor I have no idea if he is giving me good treatment, while he has no need to take into account the cost of the treatment, and my insurance company has every incentive to refuse to pay, without knowing the true situation. (We'll deal with health care in chapter 5.) Finally, mar-kets fail to work well if some people make decisions that affect bystanders: when a driver buys gasoline from a gas station, that is all very well for the driver and the gas station but not for the bystanders, including other drivers, who have to breathe the re-sulting carbon monoxide.

These three big problems are called "market failures": scarcity power, which we discussed in chapters 1 and 2; missing informa-tion, which we will discuss in chapter 5; and the subject of this chapter, decisions that have side effects on bystanders. Econo-mists call the side effect an "externality" because it lies outside the original decision, for instance, the decision to buy gasoline. Whether because of scarcity power, incomplete information, or an externality, when the economy fails to live up to the idealized "world of truth," trouble is in store.

How drivers affect bystanders Washington DC, London, Tokyo, Atlanta, Los Angeles, and Bangkok, and indeed any of the world's great cities, are full of cars, buses, and trucks. Those vehicles seriously damage the hap-piness of innocent bystanders. They cause severe air pollution. Admittedly, London's current air pollution is not as severe as the "Great Stink" of the 1850s, in which tens of thousands died of cholera. But still, air pollution from traffic is not trivial: many thousands of people die because other people want to drive. Around seven thousand people a year die prematurely because of traffic pollution in Britain, a little more than one in ten thou-sand.In the United States, the Environmental Protection Agency estimates that fifteen thousand people die prematurely because of the particulate matter produced from sources such as diesel engines. Within urban areas like London, the cost of delays from congestion are even worse, if you consider the number of hours spent sitting in traffic as being in any way a significant loss of pro-ductive or enjoyable life. Then there is the noise, the accidents and the "barrier effect," which discourages people, and particularly children, from walking to school, the local stores, or even to meet their neighbors across the street.

People are not fools: it's almost certainly true that anyone tak-ing a trip in a car is benefiting from driving. But they are doing so at the expense of everyone else around them-the other driv-ers stuck in traffic, the parents who dare not let their children walk to school, the pedestrians who risk their lives dashing across the street because they are tired of waiting for the light to change, the office workers who even in the sweltering summer cannot open their windows because of the roar of the traffic.

Because each driver who gets into his car is creating misery for other people, the free market cannot deliver a solution to the problem of traffic. The external effects of congestion and pollu-tion are important departures from the "world of truth." In the "world of truth" every act of selfish behavior is turned to the common good. I selfishly buy underwear because I want it, but in doing so channel resources into the hands of underwear manufacturers, and do n.o.body any harm. Textile workers in China, where the underwear is made, selfishly look for the best job, while manufacturers selfishly look for the most capable employees. All of this works to everyone's benefit: goods are manufactured only if people want them, and they are manufactured only by the most appropriate people to do the job. Self-centered motives are put to work for everybody.

Drivers are in a different situation. They do not offer compensation for the cost they inflict on other people. When I buy underwear, the money I spend is compensation for all of the costs incurred in making it and selling it to me. When I take the car for a drive then I do not even need to think about the costs incurred by the rest of society as I avail myself of the free roads.

Different kinds of prices: Marginal and average It is not quite fair to say that drivers can use the roads for nothing. In the United Kingdom, it's not legal to drive a car, or even to park it on public streets, unless you have paid a sizable annual tax called "Vehicle Excise Duty." Many states in the United States have a similar tax. Gas and diesel fuel are also taxed heavily enough to cause great resentment. In the autumn of 2000, for example, a series of protests against high fuel prices prevented fuel reaching the country's gas stations, and brought Britain to a standstill. In Britain, drivers pay 20 billion in taxes on cars and fuel every year; in America, the figure is around $100 billion. To ask "have they paid enough?" is to ask the wrong question. The right question is, "are they paying for the right things?" The answer is no.

There are two different concepts of price at play here, and the distinction matters. The average price that a driver pays for a journey across a city is quite high if the driver is paying an annual license fee. But the price that the driver pays for one extra trip across the city is low: the trip doesn't burn much fuel and drivers are not charged for extra trips. Once you've paid for the right to take the car on the street in the first place, you don't get a dis-count for low mileage: you might as well drive and drive, because it won't put a penny on your tax bill. That is the difference be-tween the average price and the marginal price, which is the price for one extra trip.

To understand why the difference matters, let's turn to alcohol. When I was in college, clubs and societies used to have big par-ties where some people didn't drink at all and, less surprisingly, most people drank far too much. This was because there were two types of ticket. "Alcoholic" tickets allowed unlimited booz-ing after payment of an up-front fee of, say, ten pounds (at that time, about fifteen dollars). The other type of ticket was a lot cheaper, and you had to drink rancid orange juice instead and stand in a corner while the drinkers got more and more obnox-ious. Turning up and having a couple of beers was a pretty ex-pensive proposition, so most people preferred either to maximize the value of the unlimited drinking opportunity, or opt out of drinking alcohol completely. Of course, the result was chaos, al-though some people felt it made for pretty good parties.

Since the university felt that the drunkenness represented a problem, they considered dealing with it at the next party by raising the up-front fee to, say, twenty pounds (about thirty dol-lars). But the likelihood would be that while a few people would switch to being disgruntled orange-juice drinkers or give up on the society altogether, most of the drinkers would decide there wasn't much point in a party without drinking. Grumbling, they would empty the contents of their wallets. Later in the evening, many of them would empty the contents of their stomachs.

The university misunderstood the problem. They understood that people were drinking too much and correctly thought that the solution probably involved raising the price of drinking. The problem is that there are different ways of describing the price of drinking. There's the price of being a drinker: ten pounds. There's the average price of a drink: for the typical student who has twenty drinks, this is fifty pence. Then there's the marginal price of a drink, which is zero. Once you've paid the up-front fee, you might as well keep drinking.

Question: if you were running the university, would you deal with the problem by: (a) raising the up-front fee for drinking?, (b) buying better orange juice?, or (c) sc.r.a.pping the up-front fee and charging people for what they drank?

Better orange juice might be nice, but the Undercover Econo-mist would humbly suggest that the solution to the underlying problem is c.

Now, back to traffic congestion. If you were advising the secretary of transportation you might suggest an a.n.a.logy with student parties. Currently, potential drivers have two options: they can cough up a large up-front fee and drive as much as they like; or they can not drive at all. This second option, the "orange-juice" option, requires them to bike, use public transportation, or walk- although as with the student party, the more people who choose the first option, the less attractive the second option becomes.

You might even propose some policy options: (a) raise the up-front fee for driving; (b) supply better "orange juice" (more buses, better trains, cycle routes, pedestrian crossings); or (c) sc.r.a.p the up-front fee and charge people for the trips they drive.

All of these options could be expected to reduce traffic congestion to some extent, perhaps to an important extent. But it is option (c) that attempts to deal with the cause of the problem. Drivers do not live in the "world of truth"; that is they do not pay the true cost of their actions, including the "externalities" or side effects that affect bystanders. Option (c) tries to make them pay that cost; we might call it an "externality charge."

Currently, every potential driver is being offered the same kind of deal as partygoing students: put up a wad of cash in exchange for an unlimited binge, or pay nothing and receive nothing in return. There are no half measures.

Student parties were not livened up excessively by the fact that drinks worked out at fifty pence (less than one dollar) on average: they were livened up excessively by the fact that the next drink was always free. Similarly, congestion is not caused by the fact that the tax on a car trip is fifty cents on average: it is caused by the fact that the next trip is always free.

We must not get obsessed with the question of how much drivers pay on average. Certainly, how much tax any type of person pays on average is an important question of distribution. While distribution is important, however, it doesn't have a big impact on whether our streets are clogged up and our cities are polluted.

What matters much more for congestion is the price drivers pay at the margin; or, to put it another way, the price drivers pay to make one extra trip. Cars don't cause much pollution or con-gestion, after all: car trips are the problem. Universities would encourage appropriate levels of drinking by charging students per drink. Similarly, the Department of Transportation would encourage appropriate levels of driving by making drivers pay for each trip.

Pricing should reflect the damage I've been oversimplifying, as usual. In most European countries, drivers do pay a tax per mile in the form of a high tax on fuel. But the tax on fuel doesn't closely match the costs that drivers inflict on each other and on nondrivers. People in rural areas pay the taxes (typically they spend between a quarter and a third as much again on gasoline as those in urban areas), but it is the commut-ers in the London, New York, or Paris rush hours who are caus-ing the most serious congestion, severe air pollution, and noise. The same trips made in the small hours of the morning do not cause congestion, although pollution and noise are still a prob-lem. Make a similar trip between two houses in Alaska and you do not cause congestion. The noise is likely to be heard only by the occasional stray caribou. The damage caused by pollutants is much reduced, because many of them will disperse harmlessly. If the idea of a charge on driving is that each driver faces the costs of his actions, the rush-hour New York driver should pay more because he is causing more harm to others. Whatever level of externality charge turns out to be appropriate, if it is to reflect the truth, it should vary according to time and place.

The idea of an externality charge is not to discourage every-one from doing anything that might inconvenience anyone else; it is to get them to take into account the inconvenience they cause to others. To take an extreme example: if I go walking in Virginia's Blue Ridge mountains, it is nice to be able to take in the natural beauty of the place in relative solitude, and so it's mildly annoy-ing to find the trails cluttered with other people. They may be inconveniencing me, but it would not be efficient to forbid their trip because it gives them so much pleasure and me so little trouble.

Externality charging needs to strike the right balance between pleasure and trouble; it must reflect the cost of the externality . . . but no more. We should aim to make ours a world where people feel free to do things they enjoy, even if others are mildly incon-venienced, but also one where we all refrain from harming other people if the effort involved to avoid harming them is small. We discovered in chapter 3 that perfect markets deliver this world, at least within the sphere that markets operate. Perfect markets can-not make us smile at pa.s.sersby or love our families, but they can make sure that we get a cappuccino if and only if we are willing to pay more than the true cost-which includes the cost in time and trouble of the baristas, the bean pickers, the entrepreneurs, the machine manufacturers, and the rest. In other words, perfect mar-kets allow us to feel free to do things that we enjoy only if our enjoyment outweighs the trouble caused to make it all possible.

This is why economists are fairly relaxed when markets seem to be working well. But we are also vigilant for the many market failures. So how do we make sure that when deciding whether to drive across town, I can be sure that the benefit to me outweighs the cost to everybody else? There's no need to worry about costs and benefits that are part of an efficient market transaction. So, if oil refining and gasoline retailing are perfect markets (contrary to popular belief, they are not far off), then the trouble it took to refine and distribute the gasoline is fully represented in the price. I will not buy gasoline unless the benefit I get from it is greater than the trouble it took to refine and distribute.

Instead, we should worry about costs and benefits missing from the market transaction. The pollution from the gasoline causes local poisoning and global warming, and the majority of the pol-lution damage when I burn a tank of gasoline is not caused to me or to the oil company. The trick is to mimic perfect markets by getting drivers to pay all of the costs of their actions: since they have already paid the market costs to the oil company, they also need to pay, on top of that, the externality costs. These external-ity costs are the costs inflicted on others but not borne by the driver or the oil company.

We now have all the elements in place to design an externality charge. We know that there may be costs and benefits that spill over from an individual choice or a market exchange, and if so, this will be inefficient (translation: we could do better, making at least one person better off and n.o.body worse off). We also know that if we want to change behavior to correct the inefficiency, we need to address prices at the margin, not average prices. Third, we do not need to worry about costs, which have been incorpo-rated into a well-functioning market transaction, only external-ity costs, which have been left out. Fourth, our marginal pricing should reflect those externality costs accurately. It's not enough simply to ban any behavior we don't like. Instead, we should be focusing on cases where the active person gains small benefits but causes large costs for others.

Two objections to externality charges A charge for externalities is effectively a government tax, and all government taxes are controversial. Externality charges are often attacked from two opposing ranges of moral high ground.

How much do people spend on fuel?

Percent of Income 6 5 4 3 2 1

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