The Logic of Maximizing Behavior and Maximizing in the Marketplace

Read these sections revisit the concept of marginal costs and benefits within the context of the consumer's (and the firm's) maximizing behavior. The later pages in this section define two new concepts: consumer surplus and producer surplus. Take a moment to read through the stated learning outcomes, which should be your goals as you read through the chapter. Attempt the "Try It" problem for each section.

The Logic of Maximizing Behavior

Case in Point: Preventing Oil Spills

Do we spill enough oil in our oceans and waterways? It is a question that perhaps only economists would ask - and, as economists, we should ask it.

There is, of course, no virtue in an oil spill. It destroys wildlife and fouls shorelines. Cleanup costs can be tremendous. However, preventing oil spills has costs as well: greater enforcement expenditures and higher costs to shippers of oil and, therefore, higher costs of goods such as gasoline to customers. The only way to prevent oil spills completely is to stop drilling for and shipping oil. That is a cost few people would accept. But what is the right balance between environmental protection and the satisfaction of consumer demand for oil?

Vanderbilt University economist Mark Cohen examined the U.S. Coast Guard's efforts to reduce oil spills when transporting oil through its enforcement of shipping regulations in coastal waters and on rivers. He focused on the costs and benefits resulting from the Coast Guard's enforcement efforts in 1981. On the basis of the frequency of oil spills before the Coast Guard began its enforcement, Mr. Cohen estimated that the Coast Guard prevented 1,159,352 gallons of oil from being spilled in 1981.

Given that there was a total of 824,921 gallons of oil actually spilled in 1981, should the Coast Guard have attempted to prevent even more spillage? Mr. Cohen estimated that the marginal benefit of preventing one more gallon from being spilled was $7.27 ($3.42 in cleanup costs, $3 less in environmental damage, and $0.85 worth of oil saved). The marginal cost of preventing one more gallon from being spilled was $5.50. Mr. Cohen suggests that because the marginal benefit of more vigorous enforcement exceeded the marginal cost, more vigorous Coast Guard efforts would have been justified.

More vigorous efforts have, indeed, been pursued. In 1989, the Exxon oil tanker Exxon Valdez ran aground, spilling 10.8 million gallons of oil off the coast of Alaska. The spill damaged the shoreline of a national forest, four national wildlife refuges, three national parks, five state parks, four critical habitat areas, and a state game refuge. Exxon was ordered to pay $900 million in damages; a federal jury found Exxon and the captain guilty of criminal negligence and imposed an additional $5 billion in punitive damages. In 2008, The Supreme Court reduced the assessment of punitive damages to $507 million, with the majority arguing that the original figure was too high in comparison to the compensatory damages for a case in which the actions of the defendant, Exxon, were "reprehensible" but not intentional.

Perhaps the most important impact of the Exxon Valdez disaster was the passage of the Oil Pollution Act of 1990. It increased shipper liability from $14 million to $100 million. It also required double-hulled tankers for shipping oil.

The European Union (EU) has also strengthened its standards for oil tankers. The 2002 breakup of the oil tanker Prestige off the coast of Spain resulted in the spillage of 3.2 million gallons of oil. The EU had planned to ban single-hulled tankers, phasing in the ban between 2003 and 2015. The sinking of the Prestige led the EU to move up that deadline.

Tanker spill crises have led both the United States and the European Union to tighten up their regulations of oil tankers. The result has been a reduction in the quantity of oil spilled, which was precisely what economic research had concluded was needed. Whereas the total quantity of oil spilled from tankers in the 1970s was over 3 million tons, for the decade of the 2000s the total was 212,000 tons - a decline of over 90% - even as the amount of oil shipped rose dramatically.

The year 2010 saw another kind of major oil spill resulting from offshore drilling. The explosion of the Deepwater Horizon oil rig in the Gulf of Mexico on April 20, 2010, in which 11 workers were killed and 17 injured, led to a spill of 4.1 million barrels into the Gulf over a 3-month period. This spill was about 40% larger than the second largest offshore drilling spill off the U.S. coast and 19 times bigger than the Exxon Valdez spill. So far, no major legislation affecting oil drilling has passed, though, after a five-month drilling moratorium, the U.S. Department of the Interior has made changes to its enforcement practices.

Whether or not new legislation concerning offshore oil drilling is needed and how it should be constructed is being hotly debated. A preliminary study by Alan Krupnick, Sarah Campbell, Mark A. Cohen, and Ian W. H. Parry for the organization Resources for the Future estimated the annual benefits of preventing a catastrophic spill to be between $16.1 billion and $29.5 billion. The annual costs of a ban they estimate to be about $65 billion, from which they conclude that cost-benefit analysis does not justify a ban. On the other hand, they argue that regulation that would increase the costs of extraction by 10% or $11 billion annually would pass a cost-benefit analysis test and that regulation that raises extraction cost by 20% or $22 billion would pass the test at the upper end of the benefits estimate only. It should be noted that the Oil Pollution Act of 1990 was passed about a year and a half after the Exxon Valdez incident.