Will household compensation change behaviour?

CO2The Government has struggled to sell its message that households will receive compensation under a carbon price. There has also been far too little explanation as to what a well-designed compensation scheme can achieve. It would seem that some politicians who aspire to being good economic managers do not seem to understand a simple, but counter-intuitive, lesson from first year economics: namely, it’s the relative price that matters.

Consider the following example.

Imagine that a slice of pizza and a hamburger sold for $5 each and that as a consumer you thought both were pretty good options for lunch. Given a slight preference for pizza, however, let’s assume on most days you buy the pizza.

Now imagine the Government comes along with a pizza tax of $5 per slice and at the same time the Government announces that it offer all consumers, regardless of whether they ate pizza or not, $5 per day in compensation.  The price of pizza is now $10 while hamburgers are still $5…which would you buy? Many people at this point are likely to switch to hamburgers and keep the extra $5.

But a well-designed compensation scheme can do two important things simultaneously. First, it can make sure that those who cannot change their behaviour need not be any worse off. That is, as is the case in the example above, a person who was hooked on pizza would keep paying the $10 and, thanks to the $5 compensation, not actually be any worse off in absolute terms.

But the second thing a well designed compensation scheme will do is change the relative prices. By making the relative price of pizza $5 more than a hamburger, a lot of people will change their decision.

The introduction of a carbon price is designed to make energy more expensive and the introduction of a compensation scheme is designed to make sure that vulnerable people who can’t change their behaviour will be no worse off. But at the same time those same people will have an even bigger incentive to hunt for ways to save energy than before.

On the other hand, if you offer ‘compensation’ to big polluters by simply exempting them from 94.5 per cent of their carbon tax bill, as proposed by the Rudd Government and supported by many industry groups, then in effect you simply cut the $5 pizza tax to 25 cents. It might change some polluters’ behaviour, but in reality, if they want to keep polluting then they will simply pay up.

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