Since the government of Alberta announced its intention to implement a carbon tax, there has been a sudden burst of skepticism, of commentators claiming that carbon pricing schemes are ineffective. Critics from both right and left — from Margaret Wente to Naomi Klein — have claimed that the incentives provided by a carbon price are too weak to constitute an effective response to a problem as extensive and as severe as global climate change.

My experience has been that, when you get into a debate with people about climate change, this is always the last-ditch argument. Critics usually start out claiming that carbon pricing “commodifies nature,” or that it constitutes a “tax on everything.” After you explain why this doesn't make any sense, they reach for the backup argument: “Anyhow, they don’t work” — as in, carbon taxes, or a cap-and-trade system, won't actually reduce consumption of fossil fuels.

This is the line that Stephen Harper clung to during the past electoral campaign — whenever he was pressed to provide a rational basis for his opposition to carbon taxes, he claimed that they would not work.

Actually, the first time I heard this argument was from a Suncor representative, who put it to me something like this: “For your typical Canadian, a five- or 10-cent increase in the price of gas isn't going to get them to stop driving.”

Of course, for anyone who wants to know what the facts are, it's pretty easy to find data on this. There are literally hundreds of studies. Economists calculate something called the “price elasticity of demand” of various goods, which represents the percentage change in consumption that one can expect, in response to a certain percentage change in price. What Harper, as well as my friend from Suncor, were claiming is that the price elasticity of gasoline is zero. This is categorically false.

When one looks at the studies in the aggregate, it turns out the average finding is that the short-term price elasticity of gasoline is approximately 0.25, which means that a 10-per-cent price increase in gasoline results in a 2.5-per-cent reduction in the amount consumed. This is relatively inelastic, as one would expect, given that many people are locked into their current patterns of consumption, particularly their commuting routine, which accounts for a large portion of their gasoline spending.

As a result, economists also estimate the long-term price elasticity. It turns out — again, as one would expect — that during periods of less than a year, elasticity is 0.25, but that afterwards it increases to 0.6 on average. In other words, a price increase of 10 per cent, after a year or more, results in a decline in consumption of around 6 per cent.

One can see obvious reasons why this might be so. Over time, people move around a lot. When people decide where to live, they sit down and do the math (indeed, they are forced to sit down and do the math, by their mortgage lender) to figure out exactly how much house they can afford. When determining how much they can borrow, they must calculate all of their other expenses, including commuting costs. This is not a negligible sum, since many suburban households spend $300-$400 per month on gasoline. Changing the price of gasoline affects these calculations, which then starts to generate effects over the long term, as people buy new cars, and more consequentially, as they change houses. Unsurprisingly, studies have shown that an increase in gasoline prices reduces demand for houses in outer suburbs.

This is very straightforward. There is, however, a more subtle point, which professional economists take for granted, but that is often lost on the rest of us. It explains what is wrong with my friend from Suncor's intuition that a carbon tax will be ineffective, because it will not change the behaviour of the average Canadian. The correct response is to observe that it is not supposed to change the behaviour of the average Canadian. Its effects will be felt at what economists refer to as “the margin.” Indeed, the tendency to focus on the average consumer, rather than the marginal one, is one of the major reasons that non-economists get confused about how the economy works.

So what is this mysterious “margin”?

The concept arises from the observation that people’s willingness to pay for things varies considerably, and yet most of the time companies have to charge everyone the same price. For example, I'm willing to pay $8 or $9 for a good breakfast, but when I go to McDonald's I get charged $5 like everyone else. That's because McDonald's is pricing its breakfast with two competing objectives in mind, the first is to sell them at a profit, but the second is to sell as many of them as possible.

The company's math tells them that they can make more money selling a very large number of breakfasts at $5 than they can selling a much smaller number at $6 or $7. That's because, by dropping the price from $6 to $5, they bring in a new batch of customers — people for whom $6 is actually too much to pay for breakfast, but $5 is just right. These are the marginal consumers. And it is the behaviour of these marginal consumers that actually drives the movement of prices in a market economy.

Now suppose you work somewhere in middle management at McDonald's, and you go to your boss with a great new idea. “Hey,” you say, “we should charge more for breakfast. Maybe $6. After all, the average Canadian is not going to stop eating at McDonald's, just because the price of breakfast goes up by a dollar.”

Anyone who understands business can see right away that this is a stupid suggestion — even if you're right that the average Canadian can afford to pay $6 for breakfast. The point is that it's not about the average Canadian, it's about the marginal Canadian. If McDonald's raised the price of their breakfast by $1, they would lose business, because there are some people who could no longer afford that, or who would not longer regard it as a “deal,” and so would go elsewhere, or would just stay home and eat cereal.

The story with carbon taxes is exactly the same. Just as I am willing to pay $8 for breakfast, I would probably pay $2 or more per litre for gasoline. After all, I make a good salary and I don't do much discretionary driving. But this just goes to show that I'm not the marginal consumer of gasoline. There are, however, many people who are driving, right now, only because gasoline prices have been averaging around $1 per litre. Raise that price by five or 10 cents, and they will actually drive less. This may seem unlikely, but a moment's reflection shows that it must be true — if it isn't, then gas companies have been mispricing their product.

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This is the major reason that armchair pundits tend to get it wrong, when it comes to estimating the effects of carbon prices. They look at their own consumption habits and figure it wouldn't make much difference to their own bottom line. But in thinking about things this way, they misunderstand one of the most fundamental features of how a market economy operates. Carbon prices will work, for exactly the same reason that capitalism as a whole works — because both consumers and businesses respond to the incentives that prices provide at the margin.

Joseph Heath is a professor in the School of Public Policy and Governance at the University of Toronto.

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