Thursday, December 6, 2007

Inelastic Demand and the Extinction of Species

I thought I might describe an economic mechanism that works specifically toward species endangerment and extinction. That has to do with commodity price inelasticity.

Everyone remembers about price elasticity, right? Well, let’s review anyway.

The demand curve for a commodity is considered elastic if a certain differential percentage increase in supply results in a less than that differential decrease in price. Conversely, if a differential percentage increase in supply results in a greater than differential percentage decrease in price, the commodity is considered inelastic. These relationships also apply on the way down on the supply curve..

This relationship means that, for inelastic demand commodities, increases in total supply result in actual decreases in total income for all aggregated suppliers. For example, if a 1% increase in supply results in a 2% drop in price, all suppliers will receive only 1.01*0.98 income, i.e. slightly less than 99% of their original income. One frequently cited example is farm commodities. As food supplies grow, farmers as a whole receive less and less money. While this may be seen as bad by farmers, it positively benefits the nation as a whole, since less and less must be spent on food, which frees up resources for other things.

Now consider the converse case, where the supply of the commodity is decreasing. Under decreasing supply conditions, the share of gross national income that goes to the suppliers of that commodity increases, in both relative and absolute terms. Thus, it would pay suppliers as a whole to reduce the available supply.

This is the usual argument made against commodity monopoly: if a single (or small number) of suppliers can restrict supply sufficiently, it is possible to increase total income by producing fewer goods. Similarly, even if there are a large number of suppliers, a restriction in supply will actually benefit suppliers as a group. So, for example, minimum wage laws benefit low wage workers as a group, though it may penalize some low wage workers by reducing the number of jobs. The monetary loss from reduced jobs, however, will be less than the monetary increase due to increased wages. Similarly, farmers as a group are benefited by crop restrictions, such as tobacco and peanut allotments.

A naturally restricted commodity does not need a regulatory restriction to achieve monopolistic effects. In the case of a plant or animal species, especially one that is not domesticated, over-harvesting can reduce the future availability of that commodity to all suppliers. Thus, individual suppliers do not need to have price-setting power; all they need to do is to harvest as much as they are able. This results in a restriction of future supply, which leads to higher prices, which increases their own total income.

Presumably, at some point one reaches diminishing returns, where the commodity becomes a luxury good with a more elastic demand curve. However, by that time the species may be endangered, and any “fellow-traveler species” (think dolphins/tuna), may be extinct.

I am reasonably certain that this mechanism is at least as much responsible for the decline in world fish catches as the conventional “tragedy of the commons” phenomenon. In a “tragedy of the commons” scenario, privatizing the commons might have a useful effect. In an inelastic demand scenario, it would not help at all, unless there were a single private entity monopolizing all fisheries.

This, of course, is identical to the case of governments producing a regulatory agency, except that the benefits to private ownership accrue only to the owners of the resource.


Anonymous said...

Please explain this idea more simply. Why should there be inelastic demand for, say, tuna or cod?


James Killus said...

Well, first, inelastic demand for, say, cod, is an empirical fact. It can be determined by examining the price/demand curve for cod as the price changes, or conversely, as the supply changes. When the supply of cod goes down, the price goes up more rapidly than the decline in supply, thereby yielding more income for all cod suppliers in aggregate.

Why this should be the case is probably because food is a necessity, and second, fish is one of the lowest cost sources of protein. Thus, there isn't much substitution of other commodities until the price of fish goes up considerably, and second, people need to eat.

If you add in any reasonable discount rate (i.e. a dollar today is worth more than a dollar tomorrow), it makes economic sense for fish harvesters to drive the supply of fish right down to marginal population levels, which may be too low for the continued existence of many fish species.

But my real point is that this is not an example of a "tragedy of the commons." It will apply to any combination of suppliers of fish, so long as they are trying to maximize long term monetary gain, rather than maintaining a long term food supply. This would be one of the worst cases of "market failure" on record.

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