Friday, January 28, 2011

Speaking of Negative Costs

Ever since the global consulting firm McKinsey & Company first published the above graph of abatement costs of various measures to mitigate greenhouse gas (GHG) emissions a few years ago, I've wondered about its implications for economic theory. Assuming competitive markets and complete information, each "negative cost" abatement measure (all those extending down from the horizontal axis) should not really exist as an opportunity because they already should have been exploited by businesses seeking to minimize costs and maximize net revenues.

It reminds me of the old joke according to which University of Chicago economists Milton Friedman and George Stigler are walking through the quad one day, when Milton suddenly spots a one-dollar bill on the ground (being much closer to the ground than George, it was easier for him to see).
Milton: "Hey George, there's a one dollar bill on the ground."
George "No, there's not."
Milton: "Look, it's there."
George: "Can't be. If there had been a one-dollar bill on the ground, someone already would have picked it up."
Milton: "You must be right."
They walk on.

On the same basis that George Stigler doubted the existence of an unclaimed dollar on the ground, any true-believing economist must doubt that significant negative cost opportunities exist for abating GHG emissions. And yet, there are reports of companies, including British Petroleum, Kodak, and BASF, significantly enhancing shareholder value through substantial emissions reductions. In 2004, Lord Browne, then CEO of  BP, wrote an article for Foreign Affairs (here), in which he reported on a company plan to reduce GHG emissions 10 percent by 2010 from 1990 levels. The company met that target 9 years early mainly by plugging leaks in pipelines, at a cost saving to shareholders of approximately $650 million.

What explains such deviations from basic economic theory? I have some tentative hypotheses, relating to behavioral economics (availability heuristics), organizational theory, and focal point theory. But, somewhat surprisingly, I don't know of anyone who has seriously tackled what seems to me a central challenge to theory.

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