Prices and substitution

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Much general equilibrium greenhouse modelling is based on a production function approach (including Nordhaus and Yohe 1983; Manne and Richels 1991; Whalley and Wigle 1991; Burniaux et al. 1992; Nordhaus 1992) such that

where X is output, E is energy, C is all other factors and F(.) is the production function.

The model first establishes a 'base run', incorporating assumptions about future supplies, demands and prices of all production factors and such parameters as 'autonomous energy efficiency improvement' (to be discussed later). This base run proceeds on the assumption that there are no unemployed resources. When a carbon tax is introduced, this raises the price of energy and, through the model's demand system, inevitably reduces the demand for it. Because the other factors are in unchanged supply, a lower demand for energy will convert, through the production function, into a lower output. If the base run is considered non-distortionary, i.e. is itself an optimum path, then inevitably output will fall. As Boero et al. note, the assumption in the general equilibrium models of full equilibrium means that 'any deviation from a "no distortions" base run necessarily involves economic costs' (Boero et al. 1991: 34). Several of the models in Boero et al. 's survey report GDP losses from the imposition of a carbon tax as a result of this modelling procedure, as shown in Figure 12.3, taken from Boero et al. (1991).

In Figure 12.3 models MR, N, WW and B take the production function approach. C, EB, ER and M use the IEA-ORAU model, which does not use a production function but links energy prices directly to GDP in a manner that ensures an inverse relationship (AB is not discussed here).

The question which will be examined here is whether the assumptions and modelling procedures which have led to this fall in output as a carbon tax is introduced are valid. The following issues will be addressed in turn.

1 Revenue recycling The revenues raised from a carbon tax could be considerable. The macroeconomic effect of the tax can be expected to vary depending on whether the tax is retained or recycled through the economy, and how such recycling is effected.

2 Unemployed resources It seems unrealistic to assume no unemployed resources at the present time, when most OECD countries have a registered unemployment rate of around 10 per cent. The existence of this unemployed pool of labour must change the energy/labour substitution possibilities and the costs associated with them. Macro models which incorporate unemployment indicate that this is indeed the case.

3 Distortions No economy is at a point of non-distortionary equilibrium. There are distortions due to current taxation patterns, which bear most heavily on labour; and there are distortions due to market failure, such as, perhaps, in the market for energy efficiency, and, of course, the negative externality exhibited by the phenomenon of global warming itself. The macroeconomic effect of a carbon tax will depend on whether the mode of recycling its revenues, or other associated policy, affects the distortions.

4 Investment and technical change One would expect changes in relative prices, implying changes in both production costs and patterns of demand, to change the relative attractiveness of investment options. They might also be expected to affect the rate and direction of technical change and, through the technical bias of energy use, perhaps also the rate of productivity growth.

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