Ethics, welfare, and markets: an economic analysis.

AuthorLence, Sergio H.
  1. Introduction

    Should society allow the sale of goods produced with child labor or with other similarly distasteful production technologies? So long as the child laborer and the ultimate consumer participate on a voluntary and fully informed basis, it would seem that welfare can only increase when these products are sold. If these goods are to be allowed, should government mandate their segregation? Should the producers and consumers of child labor bear the cost of certification, or should this be borne by the producers and consumers of non--child labor products?

    The issue described above is of importance because increasing affluence and globalization has allowed consumers in some countries to pay more attention to the ethical aspects of production processes, even where the production practices do not change the objective physical nature of the resulting products. Examples include dolphin-safe tuna, genetically modified (GM) crops, humanely treated animals, conflict diamonds, goods produced with child or prison labor, and lumber from rainforests and/or virgin growth. This issue is of recent relevance because the European Union (EU) and the United States have responded in different ways in an ongoing dispute at the World Trade Organization, with the EU generally in favor of allowing certification to be used as a form of trade restriction and imposing segregation costs on the goods produced with undesirable technologies (Mahe 1997; Tallontire and Blowfield 2000).

    There is an existing literature on credence goods that allows for a positive or negative impact on the ultimate quality of the good but where the consumer cannot differentiate it at the time of purchase (Darby and Karni 1973; Leland 1979; Pitchik and Schotter 1987, 1993; Nitzan and Tzur 1991; Wolinsky 1993). There is also a literature on production practices that impart positive ethical attributes such as with an eco-label (Nimon and Beghin 1999a, b; Kirchhoff 2000; Grolleau 2001; Bagnoli and Watts 2003). Crespi and Marette (2005) and Dulleck and Kerschbamer (2006) provide respective reviews of the eco-label credence goods literatures. Garella and Petrakis (2008) examine the market and welfare impacts of mandatory quality standards on an oligopolistic industry with firm-specific brands. In their model consumers can differentiate quality after consumption of the product. Their results show that quality improves after the standard has been implemented. The improvement in average quality increases consumer demand and eventually enhances returns to investments in quality and firm profits in general. This overall impact on firm profitability is sufficient to motivate far-sighted producer associations to impose the quality standards. Our model is different in that consumers cannot detect quality even after consumption and we do not find a profit incentive that motivates firms to organize and implement a collective standard. Crespi and Marette (2001) analyzed the welfare implications of alternative schemes to finance fixed certification costs under a public certification system and demonstrated that financing by means of a per-unit fee is efficient because it maintains competition.

    We are interested in production processes that are distasteful to some consumers but that otherwise do not affect the quality of the product and that can be employed at lower cost by some producers. In order to expand the definition to include these production practices, we use the terms "undesirable technology" and "desirable technology" to indicate whether the production process adds or subtracts ethical value. To focus on these ethical issues, we do not incorporate or examine the impact of fraud or market power.

    This article draws on the rich literature on the welfare effects of introducing GM grains (Giannakas and Fulton 2002; Furtan, Gray, and Holzman 2003; Fulton and Giannakas 2004; Lapan and Moschini 2004; Lence and Hayes 2005, 2006; and most recently Giannakas and Yiannaka 2008). Our model follows the structure of several of these studies in that we allow for a heterogeneous consumer response and a heterogeneous producer benefit. Fulton and Giannakas (2004) and Giannakas and Yiannaka (2008) address a set of market circumstances where products have identical physical characteristics, some producers benefit from this technology, and the production process is unobserved. Their focus is on consumer acceptance and market penetration, whereas ours is on overall welfare and the conditions under which market forces alone will not lead to the ideal outcome.

    To the best of our knowledge, the literature has not formally examined the market and overall welfare outcomes when goods and production practices have negative ethical characteristics. One of our first results helps explain the paucity of research in this area. The decentralized competitive market equilibrium will never lead to a situation where goods produced with the undesirable technology are voluntarily identified. This means that the labels that exist are always of the positive type, and it explains why the eco-label literature has tracked these positive labels. We show that it is instructive to broaden the definition to include negative ethical characteristics. This is true because when one acknowledges that less desirable production practices also exist, one can find outcomes under government intervention that improve upon the decentralized market outcome, provided regulatory costs are sufficiently low.

    To see how this market failure might occur, consider a stylized example based on Lence and Hayes (2006). Suppose that a great majority of households in the EU are willing to pay a premium to avoid consumption of GM grains. Suppose also that a small number of farmers in the EU find it profitable to produce these grains and that it is legal for them to do so. Once this GM grain is harvested, it will be comingled with non-GM grain and consumers will have to assume that all commodity grain is GM. If these consumers wish to purchase non-GM grain they will need to pay the costs associated with a new grain handling and transporting system. This alternative system will be relatively expensive because it will need to be able to maintain the identity of the product and because the existing bulk handling facilities will be in use for the GM grain. If the total additional costs associated with the new system exceed the savings made by those producers who adopt GM crops, then societal welfare will fall. Consumers who prefer non-GM grain will lose when GM grains are introduced, either because they keep consuming non-GM grain but must pay a higher price for it, or because they switch and buy GM grain but would have consumed non-GM grain if its price had not increased. Producers who do not produce GM grain and who do not participate in the niche market lose because GM grain prices fall. In these circumstances, it may make sense to ban production and imports of GM grains, or to require segregation of GM grains so that the bulk handling system can be used for non-GM grains, provided the costs of such regulations are not too high. A similar set of arguments could be used to motivate the segregation of livestock products from cloned animals.

    The purpose of this article is to examine the welfare aspects and uniqueness of the outcomes under both the free market equilibrium and the optimal solution to the central planner's problem. We differentiate among consumers so that they have unique preferences for and against the two technologies, and we differentiate among producers so that they face different production costs for both types of technologies.

    The unregulated market equilibrium will always result in certification costs being added to the production costs under the desirable technology, so that a niche market in the "high-quality" good will evolve as needed. This market situation may occur even if the majority of consumers strictly prefer the high-quality good and the cost savings from the undesirable technology are negligible. If certification of the desirable technology output is assumed to be the only way to identify the high-quality good, (1) then the market outcome is the same as the optimal solution of a central planner constrained to neither ban the undesirable technology nor segregate the low-quality good. However, the government has several other solutions at its disposal to improve upon the non-intervention market outcome. It can simply ban the undesirable technology, thereby eliminating all costs associated with certification of the high-quality good (albeit at the cost of enforcing the ban). Alternatively, it can require the output from the undesirable technology to be segregated and labeled (for which it will incur costs to prevent fraud), thereby shifting identification costs to those who participate in the market for low-quality good. Our contribution consists of exploring the circumstances under which the unregulated market equilibrium is the same as the optimal solution for a constrained central planner (i.e., a central planner constrained to neither ban the undesirable technology nor segregate the low-quality good) and those under which it can be improved upon by different kinds of government intervention.

    Under standard assumptions about consumer preferences and relative production costs, societal welfare under some of the regulated outcomes is higher than under the non intervention market outcome if regulatory costs are sufficiently low. The intuition is that producers employing the undesirable technology have no incentive to certify their output as such, and the market has no way to induce them to do so. This means that participants in the high-quality good market always bear the identification costs, regardless of the relative size of this market or the relative costs of certification. These additional certification costs act like a tax on the system and can result in lower welfare outcomes than might...

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