Part 2
(Part 1)
3. THE IoT PROBLEM IN ECONOMIC TERMS
One way to look at this issue is through the lens of the economic notion of negative externalities that lead to a market failure. A general assumption in Economics is that most standard markets function by aligning the interest of the producers and consumers. This point of agreement expresses the equilibrium of cost and benefit to all participating parties. A problem arises when a given transaction has a cost that does not, naturally, get factored into the cost of the product — this is a negative externality.
One common example of a negative externality is pollution — a factory making a product may be polluting a river and depriving a town down-stream of drinking water. The market for the factory’s product exists and functions, but doesn’t account for the costs of the pollution — the cost to down-stream residents. In other words, the cost imposed on the public as a whole, is larger than the cost private individuals, participating in the market are willing to accept. Such costs are called externalities and, in many cases, are not handled by normal market behavior, but, rather, become a burden on individuals/society. Market failures originating in negative/positive externalities are most commonly handled by variations of public sector interventions. For example, considering the world of preventive healthcare, we expect public monitoring of health risks and required immunization to serve as methods of prevention of disease. Diseases have a societal cost, as they impact the surrounding individuals and could be successfully mitigated only via healthy herd immunity.
In this case, , we will analyze the negative externalities created by unsecured devices, which paints a troubling picture of a market failure that has no incentive to correct itself. The field of Economics provides clear guidelines for identifying and addressing market failures rooted in negative and positive externalities. The more clearly we identify the nature of the particular failure, the more effectively we can map it to a possible solution.
4. TRADITIONAL INTERVENTIONS
4.1. CHANGES TO MARKETS ORIGINATED BY EXTERNALITIES
Externalities, and the resulting market failures, exist in many shapes and colors, occurring in many everyday interactions. They could be as small as the impact on the neighbors, when you practice your guitar, or as large as global warming and acid rain, resulting from burning coal (through a chain of reactions). To address each of these possible scenarios appropriately, a close examination and classification is required. First, we look to identify if the given externality is positive or negative, then we look to identify the exact act that produces the externality.
Determining positivity or negativity is simply done by asking if third parties end-up better off, worse off or not impacted, given a market interaction. Determining the source of the problem is done by considering the process of production and the process of consumption. Air pollution coming out of a factory is considered an externality from the production process, while smoking a cigarette in a closed space is considered a consumption externality, since no un-intended result is generated in the process of making the cigarette.
Considering the classic demand and supply interaction in a private market scenario, it can be said that the point of equilibrium expresses the point of agreement between the supplier and the demander. The supplier acts according to some cost-managing strategy and the equilibrium expresses the point on the supply curve at which the marginal cost (MC) of producing one more item will be too expensive. The consumer acts according to some benefit-managing strategy, where the equilibrium express the point on the demand curve at which the marginal benefit (MB) of consuming another item is just too low. As was mentioned previously, the presence of externalities introduces an additional cost/benefit curve which expresses the impact on society, in addition to the expected impact on individuals acting in the market. The below table summarizes the four classic externality possibilities and their graphical expressions. Given that production is cost-dependent, externalities from production will split the private cost curve into two: a private and a social cost curve. The latter will be higher or lower than the original private cost, according to the nature of the impact (positive or negative). Given that consumption is benefit dependent, externalities from consumption will split the private benefit curve into two: a private and a social benefit curve that is higher or lower than the original private benefit curve, according to the nature of the impact (if positive or negative).
In each scenario, the split introduces Deadweight Loss — the expression of the market loss/damage resulting from the inefficiency imbedded in the new market scenario. Deadweight Loss is the calculation of the extent by which the presented scenario diverges from the original efficient market, which is an expression for the change in price, over the change in quantity sold or consumed. Breaking down the damage to Marginal Damage (MD) per impacted individual is, theoretically, done by done by dividing the Deadweight Loss by the number of impacted individuals. Using the above examples of smoking and air pollution: smoking is defined as a negative consumption externality (Fig. 4.1) and its demand curve (expressing private MB) splits into two, introducing another, lower, demand curve — that of the society impacted negatively by the situation. The Deadweight Loss will be the resulting difference between the two demand curves and the supply curve. Similarly, factory-generated air pollution is a negative production externality (Fig. 4.2). Its supply curve (expressing private marginal cost) splits to introduce another, higher, cost — that of the negatively impacted society. The Deadweight Loss will be the resulting difference between the two supply curves.
Internalization is the process by which the market itself addresses the issues presented by externalities, in order to achieve the appropriate solution. This is usually done by negotiating a price on the added cost/benefit and paying it to/by the impacted side. The result of such additional payment merges back the private and social costs/benefit by adding cost or reducing benefit (given a positive externality) to, again, express the ideal equilibrium. For example, if, hypothetically, the polluting factory would compensate all impacted individuals in the exact amount of impact (assuming it could be quantified accurately), the result will be a shift of the production costs up to where it meets social cost, effectively merging the two curves back. The agreement resulting from the process of internalization is called the Coasian solution, after Ronald Coase, a Professor at the Law School of the University of Chicago, who suggested considering market compensation for externalities. While the Coasian solution is theoretically possible, in practice, it fails to solve many externality scenarios. The main reasons behind this common failure are the myriad of complexities involved in compensating for externalities. The task of calculating impacts and assigning appropriate responsibilities can be very difficult. Similarly, the number of individuals involved can be very large, which presents a real challenge for achieving a reasonable agreement, where no one party or individual takes advantage of the others (consider the challenges in the internalization of pollution impacts).
4.2. CORRECTIVE MECHANISMS
Public sector solutions for externalities can be divided into two major approaches — monetary and quantity. The monetary approach looks to correct the difference between social and private cost/benefit by imposing an additional cost/benefit, in the form of tax or subsidy payments. With negative externalities, the imposing side would pay the excess marginal damage and, by that, bring their private cost back to the level of the social cost. A positive externality will require a subsidy payment to offset the loss the benefit-provider side could make otherwise. The quantity approach, on the other hand, looks to regulate the process of production/consumption and keep it, strictly, at an efficient level. The efficient level must consider the potential externalities and, yet, keep the social cost/benefit the same as the private one (the condition for market efficiency). These two approaches can be deemed equal, since imposing a production/consumption limit will, immediately, translate into a rise/drop of costs — similar to imposing taxes. Yet, as will be discussed, having the flexibility of choosing between these two corrective mechanisms is crucial, given the variety of externality scenarios that exists.
In order to match a market inefficiency with a relevant corrective mechanism, a clear understanding of the given market is required. The ultimate goal in imposing a corrective mechanism is to pull the market back to an efficient point by eliminating the marginal damage and doing so efficiently. Efficiency, in this context, implies that a correction mechanism will provide a solution that is as close as possible to the amount of damage created. When the public sector imposes a tax payment on a polluting factory, for example, an assumption is made that this factory will accept this additional payment, as a modification to their cost curve in the form of an increase in production cost. The amount of tax imposed, reflects the amount of damage the factory introduces (MD) by producing additional product. This supposes that the factory will then produce up to the point where it can avoid paying this artificial cost. This is done by producing with minimum pollution, according to the new cost curve, up until the point at which the tax is imposed. Above that level of production, the overall price per product becomes too expensive. With this new cost-benefit analysis for companies the market will result in, overall, a lower level of production and a lower level of pollution. For each company involved, the private cost is shifted closer to that of the social cost. With quantity regulation, the logic is also straightforward. After analyzing the amount of damage imposed (MD), the public sector decides on the appropriate quantity for production/consumption. All producers/consumers must then alter their production/consumption logic to obey the given cap.
Considering the perspective of a producer/consumer generating an externality provides a ‘realistic’ look at the set of decisions involved in their behavior. In a way, when any correction mechanism is forced on them, an alternative, side-market, is created, driven by the costs and benefits for externality-reduction methods. Supply, which is driven by the private marginal cost (PMC), expresses the cost involved in changing behavior to accommodate the required reduction. Demand, which is driven by the MD, represents the marginal damage that is averted by an additional impact-reduction act. The supply slopes upward to express the diminishing marginal productivity of an item produced: the first units of impact are cheap to reduce, while completely impact-free production/consumption is incredibly expensive to have. Demand could be downward sloping or flat, based on the return per impact reduced.
Any correction mechanism imposes (directly or indirectly) a point where supply and demand for impact-reduction interact — the point where cost meets benefit. Producers/consumers will produce/consume and create externalities up to this point of equilibrium. As such, any correction mechanism has to consider the side-market it creates in order to realize the full extent of its implications. While the theory behind this approach is reasonable, in reality, the task of analyzing such a market is problematic. The main reason for this is that not all providers/consumers are equal, which implies that not all reduction costs are the same. In other words, the desired efficiency imbedded in designing a good impact-reduction equilibrium can be achieved only in so far as the public sector can correctly analyze each cost curve.
4.3. TAXATION V.S. REGULATION — GENERAL GUIDELINES
Taxation and regulation, therefore, should be evaluated based on their ability to accommodate the constraint of the variation in the prices for impact-reduction. With this constraint in mind, corrective mechanisms are examined for their ability to overcome this constraint. It seems quantity regulations, unlike corrective tax (also called a Pigovian tax), fail to provide this required flexibility. Monetary corrective mechanisms, in the form of a Pigovian tax, allow producers/consumer to engage in a cost-benefit analysis and consider their own reduction costs for a given tax price they have to follow. If consumer A and consumer B have different impact- reduction costs, each can modify their production to produce up to the point they consider beneficial. Quantity regulation, on the other hand, imposes one production/consumption cap on all involved parties, regardless of the expected variation in impact-reduction costs. The inability to accommodate variation in the market translates into greater inefficiency.
Another important dimension to consider when choosing between taxation and regulation corrective mechanisms are the implications involved in the estimation of the costs of the damage. If society assigns a high value to avoiding one more unit of externality (nuclear leakage, as an example), the market should adopt a mechanism that could express this need and control quantity better, even if this solution fails to take into account the various costs involved in this market. Graphically speaking, we say that demand for impact-reduction in such a case is fairly steep (high benefit from one more reduced unit). If society, on the other hand, assigns a lower value to each unit of externality reduced and, instead, would prefer a mechanism that could take into account the variation in market players (fighting global warming, as an example), the market should adopt a mechanism that could express this need to provide a better market fit. Graphically speaking, we say that demand for impact-reduction in this case is fairly flat (little benefit from one more reduced unit). Value assigned to eliminating one additional unit of externalities becomes another dimension to the decision on corrective mechanism
The above, therefore, provides general guidelines for the process of matching corrective mechanism and market failures. Aside from defining clearly the nature of the failure and its
costs, two additional topics are considered in this process. First, we look to identify if exist significant differences in impact-reduction costs across firms within a given market. Differences in reduction costs call for the use of taxes as a correction mechanism. Second, we assume an arbitrary general cost curve for the market and seek to understand the damage preferences in this market. If significant importance is assigned to units of externalities (over efficiency), quantity regulation is the way to go. If, instead, efficiency could be provided and reduction of additional externality unit is not highly valued, monetary regulation is the way to go.
It is important to note that a combination of the above mechanisms — taxation and regulation — exists and is considered efficient in countering negative production externalities like pollution. Tradable permits introduce quantity limits on pollution that can be exchanged. In other words, a factory holding a tradable permit for 100 units of pollution can decide to produce only 50 units of pollution and sell the permission for the other 50 units of pollution to somebody else. Introducing such a solution to the market of polluting factories, allows companies with higher reduction costs to buy some permits and avoid the expensive act of reduction. Factories with low reduction costs can sell their permits, earn some revenue, and avoid high payments. The market for tradable permits finds its own equilibrium, according to the needs of the parties involved.
