Global warming is a serious problem that has the potential to damage our planet in the foreseeable future. There is a consensus within the scientific community that it is increasing and needs to be addressed immediately. Viable solutions have been put forth such as a carbon tax, emissions trading scheme and others. So what is the issue? Scientists are giving grave warnings, and the government has solutions to reduce emissions. Easy? What is the problem? One of the most basic economic concepts learned in all first year microeconomic courses around the world can explain this seemingly bizarre behavior. Game theory – more specifically, Prisoner’s Dilemma.

If Australia implements a carbon tax and other countries do not, it will put it at a competitive disadvantage because the cost of manufacturing, exports and living will go up as a carbon tax will increase the price of some inputs and overhead costs. This will put other countries at a relative competitive advantage. This will decrease the NX component of the GDP equation as Australia’s exports become more expensive and imports become relatively cheaper. On the other hand, if all other countries implemented a carbon tax and Australia did not, Australia would become relatively more competitive.

The Prisoner Dilemma type situation becomes more obvious once the economics of the situation are analyzed. It is obvious the most beneficial outcome would be for every single country to implement a carbon tax of the same price so that no country loses its competitive advantage, and to reduce worldwide emissions. However we are currently in the prisoners dilemma where most utility maximizing countries don’t want to damage their competitive advantages with respect to trade, and hence are implementing either extremely conservative policy, no polices, or policies that will obviously not work. Each country is pursuing the strategy that will give them their best outcome, and given the post GFC global downturn in economic activity, anything seen as hindering already poor economic growth is not optimal. There is an incentive to undercut countries and not implement a viable climate change policy to gain the benefits of trade and also the benefit of reduced worldwide emissions without contributing. Not implementing climate change policy is a dominant strategy, and it is leading to a sub-optimal outcome, i.e. the Nash equilibrium is (no Carbon Tax, no Carbon Tax) if the players are Australia and all other countries.

There is a big issue at hand and a solution to reduce emissions. The fact that some governments around the world aren’t addressing it with an easy solution does appear to confuse and anger members of the population. Prisoner’s dilemma explains what appears to bizarre irrational behavior, is actually the opposite, rational behavior. The solution? Globally align climate change policy. Can this be done? Maybe, but politically it is very hard to do.

Richard Halabi

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