Why blue states are in the red

The Question:

Is there a correlation between state budget deficits and political affiliations?

The Background:

I just read an interesting article from Paul Kedrosky’s blog Infectious Greed that discusses the growing budget deficits by state. The chart below is the budget deficit as a percentage of FY 2009 general revenue. California, Arizona, Nevada, and Florida are in the top five (as is Rhode Island, surprisingly), but 41 states now face rapidly growing shortfalls.

I think the more interesting thing to observe is the heat map below that shows where these budget deficit hot spots are.

Source: CBPP

The Discussion:

This looks awful familiar to another map I’ve seen lately, but I can’t put my finger on it…

Source: Real Clear Politics

At first glance, it’s pretty apparent that budget shortfalls have a high correlation with state party affiliations in the 2008 Presidential Election. If I have time later, it’d be interesting to calculate the actual correlation between voting breakdown and budget deficit percentage. In the meantime, the visual should be enough to show the match. 4 of the top 5 states with the worst budget deficits are blue. In addition, the hottest budget deficit regions are historically blue-leaning: West Coast, New England, Mid Atlantic, and the Rust Belt. This leaves Central and Southeast US essentially untouched.

So the real question is which came first, the chicken or the egg? Are blue states more likely to run budget deficits due to increased government services and spending or are individuals more likely to vote Democrat BECAUSE of their state budget deficit?

The Conclusion:

Comparing some of the historical voting patterns of high budget deficit blue states may be a starting point. Historically blue states like California and New York are near the very top of the list for budget deficits. This would suggest Blue states are more prone to running up budget deficits.

However, several toss-up states with major budget deficits (Virginia, Ohio, and Florida) also voted Democrat in this election. This could imply that voters believe Democrats are the appropriate party to elect in order to solve the problems related to a significant budget deficit.

Both are reasonable hypotheses in my opinion, but I’d love to hear your comments on the issue.

The Nutshell:

There is a high correlation between individual state budget deficits and voting preferences in the 2008 Presidential Election. Two hypotheses exist to possibly explain this correlation, one that places blame on Democrats for excess spending, and another that suggests Democrats should lead efforts to resolve the issue.

…and not a drop to drink

This is the second part of the discussion to answer the question: “Should water, as a scarce resource, be priced according to its market value?”

Read Part 1 – “Water, water everywhere” to get the background on the topic before diving into the conclusion. Without further ado:

The Conclusion:

Each of the control mechanisms has inherent advantages and disadvantages relative to the three critical factors we listed earlier. However, I will conclude that the market mechanism is the most effective for reducing carbon dioxide emission. It offers effective constraining power in the short term and flexibility to adjust constraints for the long term. Technological improvements to meet these constrains are also much more cost effective than through taxation or quotas. These advantages more than offset the higher compliance costs relative to supply side controls.

If we only consider the three critical factors from part 1 then we can conclude that a market mechanism will also be the most effective control for water. However, there are several key differences between carbon dioxide emissions and water consumption that we must take into account for this to be an effective argument.

Capital costs for water are higher than other commodities:

According to Michael W. Hanemann, chancellor’s professor in the Department of Agricultural & Resource Economics for the University of California, “the ratio of capital investment to revenue in the water industry is double that in natural gas, and 70% higher than in electricity or telecommunications”. This requires water infrastructure to have an economic life lasting “75-150 years or more” to make the capital investment worthwhile. High capital costs, long time frames for investment recovery and massive economies of scale will significantly limit the number of players that can participate in this market. This is turn threatens the emergence of a natural monopoly industry that hurts all consumers. This has been addressed in several other capital intensive industries to varying degrees of success. In the telecom industry, federal regulations require companies to deliver competitor bandwidth to ensure a competitive market. Government regulations could be put in place that requires water pipes and other networked infrastructure components to be shared amongst competitors. This could dramatically reduce the capital cost required for new market entrants and encourage greater competition in the industry.

Water is too price inelastic for a market mechanism

Even when prices are unreasonably high, people will purchase water since their survival depends on it. In other words, water is perfectly price inelastic under extreme pricing conditions. So how can we ensure water prices don’t reach unaffordable levels for the masses?

The market mechanism could include a price ceiling that ensures the price of water doesn’t skyrocket, but is that really necessary? Desalinization technology now makes it possible to produce new, clean water. Although it is still an expensive and capital intensive process, overall costs are likely to come down as the industry develops new technology and achieves economies of scale. If a price ceiling is set above the variable cost of desalinization, then people can purchase the newly produced water during price spikes. In the long run, a price ceiling will be unnecessary since artificially high water prices will be controlled by adding to the water supply with less expensive desalinized water. That being said, water can not be instantaneously created to fill the void of a constrained water supply. Therefore, a price ceiling set at the marginal cost of desalinized water may be appropriate to prevent water speculation in the short run.

I’ve addressed two potential shortfalls of a market mechanism for water and issues reasonable modifications that can be made to accommodate them. Of course there will be many other shortfalls to address, and I encourage you to respond as such with your comments.

The Nutshell:

A market mechanism should be the backbone to address our water conservation efforts. This should be supplemented with a price ceiling to discourage water hording and encourage the development of new water production technology such as desalinization. Support systems that parallel current international food aid programs should also be put in place to ensure all individuals maintain the fundamental right to clean drinking water.

Agree? Disagree? Let me know by writing a comment.

Water water everywhere…

The Question:

Should water, as a scarce resource, be priced according to its market value?

The Background:

One of my new favorite features on The Economist is the occasional online debates they have on current and controversial issues. Last week they had one focusing on how the US should respond to Russian aggression over Georgia. The Pro side was led by none other than Princeton’s Anne Marie Slaughter. Nice to see the Tigers represent.

Anyway, the current debate statement is, “This house believes that water, as a scarce resource, should be priced according to its market value.” Do your homework first and read the debater statements for pro, con, and moderator. Also take a look at the guest contributors for their say.

The Pro side is focusing on the argument that water is a commodity, and just like many other commodities, a market system should be used to efficiently allocate the resource. Oil, electricity, and wheat are all commodities that are heavily influenced by market factors in order to achieve efficient allocation, so why shouldn’t oil?

The Con side is countering with the opposite argument that water is actually unlike any other commodity. No other commodity is so vital to life like water is. Water prices should not be dependent on the active hands of greedy investors or the invisible hand of economics. Instead, it should be distributed through responsible regulation and conservation.

The Discussion:

The crux of my argument utilizes my previous work with another recently defined commodity, carbon credits. My senior thesis, “Saving the Green: An Analysis of Hedging Strategies for the EU-ETS Carbon Dioxide Market”, analyzed different forms of control mechanisms and their ability to effectively reduce the emission of carbon dioxide in a cost effective way. The lessons learned from this previous research could be useful in analyzing this similar problem regarding water. Although water and carbon credits are different in many ways, I will argue that these two commodities share several traits that are especially relevant in picking an appropriate control mechanism.

1. The supply for both commodities is constrained. A failure to meet this constraint will result in significant public negative externalities
2. Both commodities have the potential for vast improvements through cost effective research and innovation
3. Enforcement must be feasible and all-inclusive to successfully maintain the aggregate target for each commodity

Any attempts to regulate the use of water or carbon credits through control mechanisms should take strong consideration of these three factors. I propose that the most appropriate control mechanism for carbon credits will also be the most appropriate for water due to these considerations. There are of course major differences we will need to address, but this framework will give us a justified foundation. We will discuss potential modifications to account for those differences later.

During my senior thesis research, I considered three general types of control mechanisms that could be used to reduce carbon dioxide emission. I’ve summarized this research into a general purpose statement for each mechanism, as well as their relative strengths and weaknesses. Keep in mind the three factors discussed above while you read the descriptions and come to your own conclusions on the most appropriate mechanism.

Taxation on carbon emission:

Purpose: Create an artificially high price for high emitting energy sources to encourage consumers to reduce or substitute energy use.

Program advantages:

• Tax rates can be adjusted to achieve necessary targets in the long run, very flexible mechanism
• Ultimately encourages highest emitters to reduce CO2 levels since they face greatest impact from the tax

Program disadvantages:

• Does not strictly determine carbon dioxide emission, targets can be surpassed in the short term
• Highest emitters is not necessarily the most cost efficient target for CO2 reduction
• Harder to enforce than supply side regulation, resulting in higher enforcement costs

Fuel supply regulation and quotas:

Purpose: Set limits on extracting fossil fuels and impose quotas on all energy imports to control how much carbon dioxide is emitted

Program advantages:

• Strictly determine amount of carbon dioxide emitted
• Limited number of energy suppliers make enforcement relatively easy

Program disadvantages:

• Lack of supply puts upward pressure on prices just like a tax
• Windfall of higher prices goes to private suppliers instead of the government who can subsidize new technology

Market mechanism:

Purpose: Set an aggregate quota of CO2 emission and allocate carbon credits to emitters. Then create a carbon dioxide market mechanism that allows firms to choose between reducing emissions in-house or purchasing credits from another firm

Program advantages:

• Gives firms flexibility to achieve carbon target in the most cost efficient manner
• Encourages participation from both low and high emitting firms
• Carbon credit allocation can be adjusted to achieve necessary targets in the long term, very flexible mechanism

Program disadvantages:

• Harder to enforce than supply side regulation, higher enforcement costs
• Difficult for companies to make cost efficient decisions due to price volatility from external market factors such as liquidity and speculation

So which of these control mechanisms is most appropriate for carbon dioxide? And can we extrapolate this to water as well? I’ll post my thoughts on this later. In the meantime, send in your comments on the topic.