It Matters Whether We Use Carrots Or Sticks

Cows in the Cornfield
Source: Shutterstock

Reducing pollution requires some combination of carrots and sticks: carrots to cajole good behavior and sticks to punish bad behavior. Everyone has an opinion about which approach is best, except for the economists who argue it doesn't matter.

People often mislearn in economics classes that carrots and sticks are equally effective. This lesson follows from a theory proposed by Ronald Coase, a British economist who won the Nobel Prize in 1991.  I say "mislearn" because the theory relies on important caveats that limit its applicability in the real world, as Coase himself pointed out repeatedly. 

Coase used the example of a rancher whose cattle live on pasture next to a farmer's corn field. There is no fence, so the cattle wander onto the corn field and eat the corn. Should the cattle rancher be liable for the damage caused by the cattle, or should the corn farmer be responsible for keeping out the neighbor's cattle? 

Coase argues that it doesn't matter, as long as liability is clearly defined, but he states two caveats: the parties (i) can negotiate freely, and (ii) know the cost of the problem and its potential solutions. 

This argument is known as the Coase Theorem. If the government in a Coasean world deemed the cattle rancher liable, then the two parties would negotiate acceptable compensation to the farmer for crop damage, or the rancher would build a fence if that were less expensive. If the corn farmer were responsible, then the two parties would negotiate an acceptable payment to the rancher to reduce crop damage, or the farmer would build a fence if that were less expensive.

In a Coasean world, we get the same number of cattle, the same amount of corn, and the same mitigation cost no matter which party is held responsible for the damage.  The only difference is who pays.

Real-world pollution policies are decidedly non-Coasean. They employ regulations, standards, and complicated trading schemes, rather than merely assigning liability and getting out of the way. For the cattle-eating-the-corn problem, real world policies would include some or all of the following:

  1. require the cattle rancher to build a fence
  2. mandate a maximum cow size
  3. require the cattle rancher to provide a certain quantity of food for her cattle
  4. require the cattle rancher to provide cattle food in proportion to the quantity of the farmer's corn they eat
  5. fund research and development of better fences
  6. fund research and development of better cattle (they're called sheep and they already exist)
  7. allow the rancher to pay a different rancher to keep her cattle off the corn farmer's land
  8. tax the rancher per cow owned
  9. tax the rancher per bushel of the farmer's corn eaten
  10. place a cap on the total amount of the farmer's corn the cattle can eat, but don't restrict which cows eat how much

For those scoring at home, (1) is old-fashioned regulation, (2) is CAFE or appliance standards, (3) is the RFS, (4) is the LCFS or RPS, (5)&(6) are R&D subsidies, (7) is offsets, (8) is a VMT tax, (9) is a Pigouvian tax, and (10) is cap and trade.

Economists often react to such policy lists with exasperation because they appear inefficient. These economists say that policy makers should impose a pollution tax or implement a cap-and-trade program, and then they should eliminate all the other policies. By setting the tax or cap, they resolve the problem raised by Coase's first caveat: in the real world there are too many affected parties for everyone to negotiate a solution with everyone else. 

As in the Coasean case, it doesn't matter whether they choose the tax or the cap. The tax would be a stick; the cap-and-trade program would be a carrot for those who pollute below their share of the cap and a stick for those above.  Either would produce the desired outcome at lower cost than the other policies, all of which prescribe certain actions rather than allowing the parties to choose the least costly action.

But, this analysis ignores Coase's second caveat: that we know the costs of the problem and its potential solutions. Pollution costs are often hard to measure, which means the affected parties will disagree on them, creating political barriers to mitigation. The cost of potential solutions is often unknown because the best solutions haven't been invented yet. 

By analogy to Coase's example, the solution to many cattle-eating-the-corn problems is a new type of fence that is yet to be invented. We need to fund research and development in fence design and figure out how to transition away from the current fence technology.  Politically, that may require compensating firms that produce the current inadequate fences.

Solving pollution problems often requires two things: (i) new technology and (ii) a disruptive transition to the new technology. Policy should focus on wide-ranging research and development (wide-ranging because we don't know which technologies will be successful) and judicious use carrots and sticks to manage the politics and economics of the transition.

Does this mean we should pay dairy farmers to capture methane from dairy manure and turn it into biogas, rather than mandating reduction of those emissions?  Does it mean we should pay farmers to reduce tillage to preserve soil carbon?  Does it mean we should subsidize oil refineries to re-purpose for renewable diesel production?  I don't know, but I think research into these questions should highlight the role of these policies in facilitating transition rather than their efficacy in comparison to a hypothetical Pigouvian tax or cap-and-trade program.


Postscript: This would have been my first Ag Data News article without data or a chart. We can't have that, so here's US carrot production.

Carrot production
Source: NASS Quickstats​​​​


Postscript 2: In writing this article, I learned that people on the internet are wrong about carrots and sticks. Some people think the term refers to tying a carrot to a stick and holding it in front of a donkey.