The Sunk Cost Fallacy: Why “We’ve Already Paid for It” Is Bad Economics

 

One of my favorite ways to start the semester is by introducing a concept many students are at least tangentially familiar with: opportunity cost.

Closely tied to opportunity cost, and to a core economic assumption about marginal decision-making to maximize well-being, is the sunk cost fallacy. While this fallacy shows up frequently in large public and private projects, I find it most effective to bring it down to a scale we’re all familiar with (and probably guilty of): sitting through a bad movie simply because “we’ve already paid for it.”

Before working through an example, one quick definition. In this post, I’ll refer to economic rent, which, following the CORE Microeconomics framework, means the extra benefit you receive from an action after accounting for all relevant economic costs, including opportunity costs. A positive economic rent means the choice improves your well-being relative to the next-best alternative.

The Initial Choice

Suppose you have two groups of friends asking you to hang out on the same evening:

• One group wants to go to the movie theatre
• The other wants to go to the pub

You can only attend one.

To keep things simple, let’s assume:

• Your time is the scarce resource, not money (Lucky you)
• You enjoy both groups of friends
• The movie starts earlier, and the pub hangout begins later

Economists often represent enjoyment or satisfaction in dollar terms, not because it’s literally money, but because it gives us a common unit to compare options.

Option A: The Movie Theatre

You’ve heard the movie is good, so you expect:

• Benefit: $50 (movie + time with friends)
• Explicit cost: $35 (ticket, popcorn, etc.)

That leaves you with a net explicit benefit of:

$50 − $35 = $15

Option B: The Pub

You know from experience the pub is always a good time:

• Benefit: $60
• Explicit cost: $50 (food, drinks, tip)

So, your net explicit benefit here is:

$60 − $50 = $10

Choosing Using Economic Rent

Using economic rent as the decision rule:

If you choose the movie:

• Net explicit benefit = $15
• Opportunity cost = forgone $10 from the pub
• Economic rent = +$5

If you choose the pub:

• Net explicit benefit = $10
• Opportunity cost = forgone $15 from the movie
• Economic rent = −$5

To maximize well-being, you choose the option with positive economic rent, in this case, the movie.

When Expectations Turn Out to Be Wrong

Now suppose you get into the theatre and quickly realize the movie is terrible.

Your original expectation of a $50 benefit was wrong. Going forward, the only enjoyment you expect to receive is about $5, purely from being with friends, not from the movie itself.

At this point, you face a new decision:

• Do you stay and finish the movie because you already paid for it?
• Or do you leave and head to the pub, which is just getting started?

This is where many of us fall into the sunk cost fallacy.

Why the Sunk Cost Shouldn’t Matter

The $35 you paid for the movie is sunk:

• It’s already been paid
• It’s irrecoverable
• It’s in the past

Because of that, it should not influence your decision going forward.

What matters now are the costs and benefits from this point onward.

The Decision Going Forward

Option A: Stay at the Theatre

• Benefit: $5 (time with friends)
• Explicit cost: $0 (the ticket is already paid)

Net explicit benefit = $5

The opportunity cost of staying is the forgone pub experience worth $10.

Economic rent = $5 − $10 = −$5

Option B: Go to the Pub

• Benefit: $60
• Explicit cost: $50

Net explicit benefit = $10

The opportunity cost is the $5 you would have received by staying.

Economic rent = $10 − $5 = +$5

The Rational Choice

The economically rational choice is to leave the movie and go to the pub.

Importantly, notice what doesn’t enter the calculation: The $35 already spent as that cost is sunk. It cannot be recovered, and including it in your decision would only lead you to make a worse choice going forward.

A Hiking Analogy

I find this analogy really helps drive the point home.

Suppose you’re on a hike and have already walked 5,000 steps. Ahead of you is a river you planned to cross, but when you arrive, the river is raging and the bridge is washed out. Crossing now would risk serious injury or death.

Should you continue just because you’ve already spent 5,000 steps getting there?

Of course not.

Those steps are sunk. The only relevant question is:

• Do you take a dangerous risk?
• Or do you turn back and choose a safer alternative for the day?

When the stakes are life and limb, the correct choice is obvious. The sunk cost fallacy feels tempting mainly when the costs are monetary or effort-based, but the logic is exactly the same.

Final Thought

What are your thoughts on the sunk cost fallacy?
Have you caught yourself thinking “I might as well finish, I’ve already paid for it or invested so much into it”?
Have you seen examples where sunk costs led to clearly worse outcomes?

Let me know in the comments.

 

Water and Wood: The Economic Trap of Common Resource Goods

 

We’re starting this post by looking at two recent articles by Stefan Labbe in BIV. The first, on October 23, 2025, highlighted the extremely low rates being charged for water use by industrial users. The second, on November 19, 2025, looked at a different but economically identical issue: unsustainable forestry harvesting rates. While water extraction and forestry might seem unrelated, from an economic perspective, they are both classic examples of the Common Resource Good trap.

This is a crucial concept because the trap threatens long-term environmental sustainability for short-term economic gain. To figure out what's happening in these sectors, let's start with the basic 100-level theory.

Key Concepts: What is a Common Resource Good?

A Common Resource Good is defined by two primary characteristics that, when combined, create a predictable market failure.

The first characteristic is that the good is Non-Excludable. This means it is difficult or costly to stop people from using the good, even if they don't pay for it. For example, trying to stop a homeowner from drilling a well or someone from filling a bucket from a lake often requires costly government intervention.

The second is that the good is Rivalrous. This means consumption by one person directly reduces the amount available for others. For instance, every tree cut down is one less for someone else, and every litre of water used is a litre that cannot then be used by another actor.

The Model of Collapse Over Time

When we first discover a common resource, the total supply, N (the total population), often seems vast, far more than the quantity demanded, Q_D, in any given year.

This initial abundance, combined with the non-excludable nature of the resource, is what leads to the Tragedy of the Commons. The short-term optimal strategy for every individual actor is to continue to extract the resource today, because an individual who cuts their own consumption is still hurt by everyone else extracting the resource anyway. This unchecked behavior leads to the resource shrinking year after year until it collapses below its reproduction threshold. You can see this process illustrated in the diagram below over five periods (N à N₅).

The Price Problem

So why doesn't a price naturally appear, even as the resource becomes scarce?

Think of a large lake with houses and businesses all around it, all using the water for various reasons. The only way a price would naturally appear is if a single actor could control access and charge money. But because the lake is non-excludable, it’s virtually impossible to enforce who is taking how much water, especially if they are drilling wells or using it for large-scale agriculture.

The cost of trying to set up a toll booth or a metering system for every single user far outweighs any potential profit. Because the good is non-excludable, the price mechanism, the force that usually balances supply and demand in a market, fails entirely.

Policy Solution 1: Property Rights

One way to overcome the common resource problem is to make the good excludable by establishing property rights.

Private Property

When we talk about shifting ownership to a single entity, or privatization, it fundamentally changes the incentives. Think about historical examples like communal grazing land or traditional agricultural plots. When everyone has access, no one has an incentive to limit their extraction or manage the land long-term. However, as soon as you fence the land and assign it to a private owner, that owner suddenly has a reason to maintain the resource's longevity. If they overgraze their cows, the cost (ruined pasture, lower land value) falls entirely on them. This incentive alignment is why privatization often solves the tragedy of the commons; the private owner internalizes the full long-term cost of their actions.

However, the way we privatize the resource can be fraught with peril and create new problems. If we simply sell off common land or resource rights to the highest bidder, it can exacerbate existing wealth inequality, turning a shared public good into a private monopoly. Furthermore, the process of privatization itself can be rife with corruption, leading to politically connected actors receiving valuable resource rights for cheap, benefiting from massive private profits while society loses out on its shared asset and shared wealth.

Nationalized Property

The other option is Nationalized Property, where the government (the Crown) retains ownership. This approach helps ensure that profits from the resource are shared by all of society and avoids the risks of exacerbating inequality by auctioning off public goods. The trade-off here is that the government now has to take on the management burden, which includes setting the laws and spending money to patrol and enforce against things like poaching or illegal extraction.

Policy Solution 2: Quotas vs. Price Controls

If the resource is nationalized and managed by the government, the objective shifts to limiting the harvest H to a sustainable level. We shouldn't think of supply as the total population N, but as the sustainable flow, the amount we can harvest in a given year while keeping the population stable. We can simplify the change in a resource population with the formula:

Change in Population = (Births - Deaths) - Harvest

The goal for Sustainable Harvesting is for the change to be zero. The government can target this sustainable level Q_H using either of two main methods:

1. Quota set at Q_H: The government sets a fixed harvest limit. This is generally the most effective "set it and forget it" tool, as the corresponding market price P_H will float based on demand for a fixed, sustainable quantity. The downside is that it requires revenue to enforce the quota.
2. Price Control set at P_H: The government sets a required price per unit extracted. This is less stable because if demand suddenly surges, the quantity harvested will automatically increase, leading to an over-harvesting of the resource unless the price is immediately adjusted.

The Policy Pitfalls and Trade-Off

Even with solid economic theory, policy implementation faces severe, very human challenges. First, estimating the exact sustainable quota (Q_H​) is complex, and the industry that stands to profit from extraction has every incentive to convince the government that Q_H​ is higher (and P_H​ is lower) than it should be, a problem known as regulatory capture.

Second, governments are often pressured to prioritize short-term economic growth (more jobs, higher GDP today) over long-term sustainability. This short-sighted goal can unfortunately be pursued for generations before the resource finally collapses.

The Real Cost of Collapse

This brings us back to the unavoidable trade-off. We have seen time and again what happens when a common resource fails. A dark Canadian Heritage Moment is the collapse of the Atlantic cod fisheries in the 1990s which didn't just hurt the economy; it created ghost towns along the coast, destroyed generational fishing cultures, and led to deep poverty and significant social issues. The ecological cost is equally devastating, often wiping out entire food webs.

The painful irony of this situation is that the very workers dependent on the industry, who are often the most vocal opponents against any government-imposed caps or quotas, were the ones who suffered the most in the end.

Restricting harvesting today causes direct, immediate pain by limiting their income, which makes a sustainable cap seem like an affront to their way of life and a gross government overstep. However, this short-termism sets them up for an even larger economic hardship in the future. By resisting the smaller, necessary economic cut today, they ensure a catastrophic, total collapse tomorrow, where the 50% hardship becomes a 100% loss of their industry.

When we enjoy the excess profits and resource extraction today, we are setting ourselves up for this type of collapse and undue future hardship.

To make matters worse, the ultimate issue of fairness and inequality is that the wealthy shareholders and corporate leaders who profit the most from excessive extraction today will likely not be the ones around to experience the pain decades from now. They take the profits, and the future generations, including the children and grandchildren of the now laid-off workers, are left to pay the cleanup bill and deal with the lost resource.

This is an ever-pressing reminder of the current state of the forestry sector in BC today. The painful question is whether we accept the immediate pain of reduced harvesting today, or wait for the complete economic and ecological devastation later.

P.S. Only hours after finishing this post, I came across the attached image - a letter from two current sitting MPs criticizing the government’s forestry policy. This post perfectly illustrates the political difficulty of the common resource problem in real time.

The issue we discussed in the blog, based on reports cited in the BIV articles, is that we are likely significantly over-harvesting our forests. However, this letter criticizes the government for reducing the harvest limits (the Allowable Annual Cut, or AAC). The MPs state that thousands of jobs are at stake and urge action to address harvest delays to protect the coastal forestry sector.

This is the unavoidable trade-off in action. While the data suggests the resource can't support the current extraction rate, political pressure demands more extraction to protect short-term jobs and avoid immediate economic hardship.

This situation is precisely why we need to be educated about the reality of the issues at hand and need to advocate for our future. If you choose to be silent, the industries and political forces who are trying to change the rules of the game in their favour, choosing short-term profits over long-term social welfare, are definitely advocating for their goals.

Traffic Isn't Just Congestion, It's A Market Failure

 

   For any of the nearly one hundred thousand residents of the Westshore of the Capital Regional District who endure a morning commute into the CRD core, you are intimately familiar with the reality of a club good being provided at zero user cost. Traffic congestion is currently high, fueled partly by population growth and largely by the ongoing construction for the addition of bus-on-shoulder lanes.

    I recently discussed this scenario in one of my classes. Given the significant interest the topic generated, it seems timely to dust off this old blog and provide an economic overview of the subject for the few nerds like me out there that like this kind of stuff, but more over and especially to counter the common rhetoric that expansions of bus or bike lanes are purely ideological.

    To effectively analyze the problem, let's abstract from reality and simplify the scenario into a more manageable framework.

Establishing Capacity and the Club Good Framework

    Let's begin by looking at a single lane of traffic. Based on data from the Highway Capacity Manual, a single lane is estimated to move between 1,500 and 2,000 People Per Hour (PPH). For our analysis, we will use the midpoint: 1,750 PPH.

Note: As the proportion of large SUVs, trucks, or commercial vehicles increases, the PPH capacity would be expected to fall. We will, however, presume the 1,750 PPH average works for our purposes.

    The defining characteristics of a club good are that it is Non-Rivalrous (up to a certain capacity) and Excludable (whether it is excluded is a policy choice).

• Non-Rivalrous (up to capacity): A rival good, like a cookie, is consumed solely by one person and thus only that person gets the benefit from the consumption. A non-rivalrous good, like a swimming pool, can be used simultaneously enjoyed by many people. Up to capacity, adding one more person does not diminish the benefit for others. Once the capacity is exceeded, the good becomes congested, and adding the last person begins to reduce the benefit for everyone, at that point, it becomes rivalrous, adding an external cost onto the society of people trying to use it.

• Excludable: This refers to the ease with which access can be restricted to those who pay. Like a cookie or a swimming pool, a road is excludable. However unlike a cookie or a swimming pool, we choose not to charge for road access. But It is entirely feasible to implement road tolls and collect a user fee; the fact that we don't is purely a policy choice.

The Efficient and Inefficient Outcomes

    Given a downward-sloping demand (Marginal Benefit) curve, with a price of zero, the quantity demanded occurs where the curve intersects the horizontal axis. For our example, let's arbitrarily set this quantity demanded at 1,500 PPH.

    

    Under the assumption that we are below capacity, this is an efficient outcome. The social and private cost of an additional person traveling on the roadway is essentially zero. Therefore, the allocatively efficient price for this good (P=MSC) is, in fact, zero.

    But what happens when demand begins to exceed the road's capacity? This could be due to rising population, or simply the surge of rush hour demand.:

    This surge in demand to 2,000 PPH at a price of zero pushes us beyond the 1,750 PPH capacity. The excess 250 PPH attempting to use the road creates congestion, which adds external costs to the rest of society. These costs manifest as:

1. Increased Commute Time: (Time is money).

2. Increased Accidents: Leading to higher insurance premiums for all motorists.

    The result is that more people choose to drive than the roadway can handle, creating negative, harmful costs that are generally paid by all of us.

The Solutions: A Comparative Analysis

    While there are many potential solutions, we will evaluate four options for their economic efficiency and effectiveness in the context of our 2,000 PPH rush hour demand:

1. A market-based solution.

2. Adding another general-purpose vehicle lane.

3. Adding a dedicated bus lane.

4. Adding a dedicated bike lane.

    Of course there are many more solutions we could consider, but for brevity (this will be long enough) we will evaluate these 4 options. 

Market Based Solution

   The most economically sound, market-based solution is congestion pricing. The government imposes a variable toll system based on the Marginal External Cost (MEC). As the number of drivers exceeds capacity, incurring an external cost on society, the toll increases to explicitly charge users for the costs they impose on others. When traffic is below congestion, the toll is zero.

Benefits:

• Internalizes External Costs: It charges the users causing the problem, whose funds can then be used to pay for alternatives.

• Incentivizes Behavior Change: Users now face an economic incentive. Some will shift to non-peak travel times or alternative modes of transportation, freeing up the road for those who cannot easily transition.

The Political Hurdle: This is often the most vehemently opposed solution, even by those who champion market forces. Why? People naturally resist paying for something that was previously free (a key parallel is the carbon tax, which charges for the external cost of pollution choices). Furthermore, this solution does not necessarily eliminate congestion; it only reduces congestion while also generating funds by charging the users who had created the costs to offset the external costs that would otherwise be paid through other means (e.g., increased insurance and general taxation). 

Adding another lane

    For simplicity, let's assume the government already owns the right-of-way and can expand the roadway without acquiring extra land.

    The common expectation is that two lanes equal 3,500 PPH capacity (1,750 x 2). However, the Law of Diminishing Returns applies. The second lane will have lower capacity due to the friction created by lane changes and merging, etc. Let's suppose the additional lane adds 1,250 PPH, bringing the total capacity up to 3,000 PPH.

    Our current 2,000 PPH rush hour demand is now well below capacity. Ignoring the well-studied phenomenon of induced demand (where new capacity incentivizes people who previously avoided traffic to now drive, leading to a concurrent surge in demand), this simplistically solves the congestion problem.

The Cost:

    A conservative estimate for building and maintaining a (3.5m x 1m) section of roadway over its 25-year lifespan is approximately $2,000 per meter. To pay for this extra lane, we need to raise $2,000 per meter through general taxation.

• Taxation Implication: Since this solution does not include a toll, the funds must be raised through general taxation, taxing everyone regardless of whether they drive on this road.

  (A note on the "Gas Tax": These funds are not dedicated solely to roads, and even if they were, they are estimated to cover only about 60% of the cost, covering only the maintenance of existing roads not expansion, leaving the expansion for the general taxpayer to cover.)

• Cost per Person/Capacity:

• Total Cost per Current Capacity: $2,000 / 2,000 PPH = $1 PPH (per meter)

• Total Cost per Future Capacity: $2,000 / 3,000 PPH = $0.67 PPH (per meter)

    As increasing the capacity has benefits that accrue into the future, it makes sense for at least part of this project to be paid for through debt financing, this way the future members of society who move to the area end up contributing to this cost as their future tax dollars will go towards paying some of this debt cost. 

Adding a Bus Lane

    This is similar to the ongoing construction on the Trans-Canada Highway between the Westshore and Victoria core. We will assume it has the same paving cost per meter as a vehicle lane: $2,000.

The Capacity Difference:

    A dedicated bus lane has an estimated capacity of 6,000 - 8,000 PPH, for an average of 7,000 PPH.

• For the same cost as adding a vehicle lane, we increase the highway's total PPH capacity from 1,750 to 8,750.

• Our 2,000 PPH demand now uses only 23% of the total network capacity, providing significant excess capacity for future growth.

Impact on Congestion:

    To bring the existing vehicle lane (1,750 PPH) back down to capacity, only 250 of the 2,000 current drivers need to switch to the bus (12.5% of peak demand).

• Why does the bus lane look empty? Let's assume 500 PPH switch to the bus.

  • The driving lane drops from 114% capacity (2,000/1,750) to 86% capacity (1,500/1,750), it flows smoothly.

  • The bus lane operates at only 7% capacity (500/7,000).

    The same 500 people who accounted for 28% of the congestion in the driving lane now take up only 7% of the bus lane's capacity. This is a far more efficient and cost-effective way to move people.

• Cost per Person/Capacity (Bus Lane):

  • Total Cost per Current Capacity: $2,000 / 2,000 PPH = $1 PPH (per meter)

  • Total Cost per Future Capacity: $2000 / 8750 PPH = $0.23 PPH (per meter)

    This is approximately 34% of the cost per person/capacity versus adding an additional vehicle lane based on future capacity - again a valid comparison as again it would make the most sense to partly debt finance this so that future beneficiaries also end up bearing some of the cost.

Adding a bike lane

    The cost of adding and maintaining a bike lane is typically a fraction of a vehicle lane's cost, partly because it can often be done on an existing shoulder and a single car trip causes vastly more road damage than a single bike trip. (Estimated that you would need over 15,000 bike trips to do same damage as a single average vehicle trip)

    To maintain a conservative analysis, let's adjust the cost based on size: a typical bike lane (1.5m x 1m) is 43% the width of a vehicle lane (3.5m x 1m).

• Estimated Cost: $2,000 x 0.43 = $860 per meter of bike lane.

The Capacity Difference:

    Bike lane capacities are estimated at between 2,500 and 5,500 PPH. We will use the average: 4,000 PPH.

• Adding this lane brings the full capacity of the network up to 5,750 PPH (1,750 + 4,000).

Impact on Congestion:

    You will hear drivers say: "But I can't bike! I have to carry groceries, ferry my kids to hockey practice, or haul tools to work!"

And that is precisely the point.

    The goal is not to force you onto a bike for every trip. The goal is to provide a safe, efficient alternative for the 2,000 PPH creating the congestion. If, for instance, 500 (25%) of trips can be completed by bike for the trip: 

(I only chose 500 for an easy round number, and consistency as it was the value I picked for the same reason for the transition to bus)

• The driving lane reduces from 114% capacity to 86% capacity (it flows smoothly).

• You get to keep your car for those essential trips, like hauling kids and groceries, but you will now encounter significantly less congestion because others have chosen to use the high-capacity alternative.

    Meanwhile, once again (given the extreme efficiency of the bike lane) this bike lane will tend to look empty as those 500 people only account for 12.5% capacity (500/4,000)

Cost per Person/Capacity (Bike Lane):

• Total Cost per Current Capacity: $860 / 2,000 PPH = $0.43 PPH (per meter)

• Total Cost per Future Capacity: $860 / 5,750 PPH = $0.15 PPH (per meter)

This is the most cost-efficient option, representing only about 22% of the cost of an additional travel lane and 65% of the cost of the bus lane.

Conclusion

    The next time you hear someone claiming that building bike or bus lanes is a waste of money or "entirely ideological," consider the economic facts.

    Building additional general-purpose vehicle lanes is by far the most expensive and least efficient way to add capacity to the system, resulting in the largest requirement for taxation increases. Conversely, shifting public funds into bus and bike lanes, for a fraction of the cost, provides vastly higher capacity, which saves all taxpayers significant money in the long run. Thus, building bus and bike lanes is not an inefficient, ideological, or wasteful expenditure; it is the most cost-effective, efficient, and fiscally conservative option to increase the operational capacity of the road network.

    That being said, we must acknowledge that the Law of Diminishing Returns applies universally. Currently, we have a relative abundance of vehicle travel lanes, which is why an additional vehicle lane results in significantly reduced returns and exorbitant costs per user. As we continue to build out our Bus and Bike infrastructure, the same Law will eventually take hold, resulting in decreasing returns for future projects. However, given the vast difference in current capacity and cost per person, the investment required to reach a point where the cost per user equates across different modes (vehicle, bus, and bike) is immense, making these alternatives the clearly superior investment for the foreseeable future.

What are your thoughts on this? Feel free to comment below.

Postscript: Notes on the Assumptions made

To maintain analytical consistency and simplify our model, the following conservative assumptions were made:

• Cost Scaling: The specific base cost chosen, $2,000 per meter of vehicle lane, is ultimately inconsequential to the conclusion. This is because all alternative costs (bus and bike lanes) are calculated as a fixed proportion (a scalar) of this base figure, derived from the relative size and PPH capacity. Therefore, if the $2,000 figure is proven too high or too low, the cost and capacity ratios that drive this analysis will remain the same. The conclusion about the relative efficiency of each mode holds true regardless of the absolute starting cost.

• Land Acquisition Costs: We assumed that adding the extra vehicle lane, bus lane, or bike lane did not require the purchase of any additional land. If land acquisition were necessary for the vehicle or bus lanes, those respective costs would increase dramatically, widening the cost differential further. The bike lane, due to its small footprint, is often easier to fit within existing rights-of-way, making this assumption most realistic for that option.

• Maintenance Costs: We calculated the cost of the bike lane as 43% of the vehicle lane based solely on its comparative size. This intentionally ignores the maintenance variable. Given that it takes over 15,000 bike trips to cause the road damage equivalent to one average vehicle trip, the expected maintenance costs for the bike lane would be significantly lower than 43%. By scaling costs based only on initial build size, we maintained a conservative, and less "skewed," estimate for the alternatives.

• Alternative Modes: For brevity and focus, this analysis was limited to the most common local congestion solutions (market-based, lane expansion, bus lanes, and bike lanes). Other high-capacity options, such as light rail or sky train systems, were excluded to keep the discussion grounded in the current projects being considered in the region.

The high cost of low taxes - Fiscal Policy part 2

                 In this post, we will spend some time talking about the high costs of low taxes. This may seem somewhat paradoxical; we will enter these discussions by defining the two primary purposes of taxation and then move into some impacts on social welfare and equity before finishing with some tangible examples of the impact of holding taxes low.

Role of Taxation:

                While it is easy to take the view that the role of taxation is just for bureaucrats and government officials to line their pockets, unfortunately, there are plenty of examples of bad actors. The fact is that taxation serves two vitally important roles. Provision of non-private goods and services and incentivizing pro-social behaviours.

Provision of goods and services.

                To simplify, we can lump all goods and services provided into one of four categories, based on whether or not the good or service is excludable or rivalrous.

                An excludable good is one such that enjoyment of the good or service can be denied if a person does not pay to access it. For example, a cookie is excludable while a tree is not. I can prevent you from enjoying the cookie if I put it behind a viewing glass and only give it to you to enjoy if you pay me first. Alternatively, even if I have a tree in my yard, behind my fence, the tree provides shade, oxygen, and visual benefits to many in the area, and the owner of the tree cannot prevent others from gaining these benefits.

                A rivalrous good is one such that only one person can enjoy the benefit of the good or service at a time. For example, again, we can use a cookie as an example of a rivalrous good, while we can use a tree as an example of a non-rivalrous one. In the case of the cookie, If I eat and enjoy the cookie, you cannot, thus the benefit of this cookie is only received by the one who gets it. Alternatively, concerning the tree, this would be non-rivalrous. If you are enjoying the view of a tree, or its cooling properties, shade, etc. this does not prevent me or others from similarly enjoying the benefits of the tree.

                Typically speaking, the free market is really good and efficient at providing goods and services which are both excludable and rivalrous (we call these private goods). Unfortunately, the free market tends to have a significantly harder time providing goods which are either non-excludable or non-rivalrous or both. Let’s take a look at an example of some of these goods.

Club Goods:

                Goods or services which are excludable but non-rivalrous (up to some capacity) are considered to be club goods. A perfect example of club goods is roads.

                Although we typically do not charge a user fee to utilize a road, it is theoretically simple to throw up a toll booth or similar technology and prevent access to the road until a user pays. Thus, although we tend not to exclude them, roads are an excludable good. Similarly, roads are non-rivalrous (up to some capacity), meaning that typically if I decide to drive on a road, I am not precluding anyone access to this road. Of course, there is a point where the roadway becomes congested (traffic) and roads switch from being a club good to being a private good.

                The problem is that to efficiently provide a club good, we need to price it accordingly. That is, a club good should have a zero-user fee when there is no congestion, however when we move to a congested state, then the good has a price to reflect the cost that one person inflicts on another by denying them access.

                If roadways (or other infrastructure such as sewer, water, bridges, tunnels, pathways, etc.) are provided by the private sector, then typically the focus of the provision of these services is around areas that face congestion. That is, the private sector would have an incentive to under-invest in these goods and services to have congestion to be able to charge an effective (profitable) price for them.

                Thus we, as a society, have typically decided that due to the social benefits that are provided by these goods and services, we should have government over private enterprise to provide this good or service and typically allow them to be provided for zero user cost and instead finance the use of the good through general tax revenue.

                The problem that this then creates of course is that individuals have no incentive not to overutilize the resource (because it is free to use) thus creating rivalrous situations (such as traffic jams).

Common Resource Goods:

                A common resource good is almost the flip of the club good discussed above. In this case, we have a scenario where the good or service is non-excludable (no easy way to charge a user fee, or no natural way to have a market form for this) but the good or service itself is rivalrous. The outcome of this is often referred to as the tragedy of the commons. Such that the resulting outcome of everyone being able to access the good without paying for its use is that each person grabs the available benefit for themselves till none remains causing a collapse of the resource itself.

                In this case, we are not typically talking about the provision of a good or service, but rather the managing of an existing (typically natural) good or service. The solution to preventing a collapse of the resource itself is through the use of legislation and imposing a tax on the utilization of this good or service through the form of a user fee. This is often seen as a permitting fee, stumpage fee, or usage fee. The purpose of such fees is to limit consumption of the good or service to prevent its collapse. This is often the key argument for forestry bylaws, resource royalties, and water fees. That is, these fees are not being collected to provide a good or service, but rather being charged to limit the consumption of a good or service, and thus promote the effective and sustainable management of that good or service.

 

Public Goods.

                The final type of good or service to look at for public provision is a public good. This is a type of good that is both non-rivalrous and non-excludable. The classic example of a public good is a park or large green space.

                Due to the nature of public goods, the private market tends to significantly under-provide them. For example, let's look at the ability of individuals to come together to fund and build a new park.

                Suppose that there is an orphaned lot in your neighbourhood, and you and all your neighbours agree that this would be a great spot for a park, some green space, a few trees for shade and maybe even a small play structure. To get this to happen the neighbourhood needs to solicit donations to fund the construction of this. While scenarios like this do happen, and we are capable of building parks in this fashion – what is the difficulty we run up against? The issue is that everyone agrees they’d benefit from the park being built. This means that they’d benefit irrespective of whether they donate money or not, as long as it is built. From an individual view then, each person would be best off if they don’t donate, or only donate very little, while their neighbour donates more, allowing the park to be built. The issue of course is that everyone hopes that their neighbour donates so that they don’t have to and the result is either that a) the park does not get built or is underbuilt or b) a significant amount of time and resources have to go into raising funds. The result of either of these scenarios is that private individuals are generally unable to provide a satisfactory amount of public goods.

                The solution then is for the government to recognize the need and social benefit received by these public goods and then provide them through general taxation revenue.  Essentially forcing each member of society to contribute a little to a project to create a public good that nearly all will enjoy, thus increasing the social welfare as a whole.

A final note on public provision of private goods:

                There of course are certain private goods (excludable and rivalrous) that we as a society have decided to provide through taxation rather than allowing the free market to provide and charge. Some examples of these are policing, fire protection, education and health care.

                In each of the above cases, the service provided is rivalrous. If you need a police officer, firefighter or health care professional you are preventing someone else from accessing their service. While similarly these services could easily be excluded. You don’t get to utilize the service unless you have paid for it first, or alternatively, will be billed after the fact.

                Even though these (and other) goods and services are technically private and thus could be provided more efficiently through the private market, we have collectively decided that the social and equity impacts of having these provided through the public realm outweigh the potential inefficiencies that arise through its public provision.

Role of Taxes continued:

                This then brings us back to completing our conversation around the role of taxes. First and foremost the role of taxes is to collect general revenues to then be able to provide Club, Public and selected private goods to the residents at zero or low user cost. This is the provision of roadways, bridges, tunnels, bike lanes, schools, hospitals, parks, green spaces, rec centres, libraries, etc. This ensures in the case of club and public goods that enough of the good or service is being provided for the benefit of society, or in the case of a publicly provided private good, that we have equitable access to the good or service irrespective of ability to pay (IE. Schools, hospitals, etc.).

                The second role of taxes is to encourage pro-social behaviour. This is best seen in the case of common resource goods. As history has shown time and time again the zero cost to utilize certain resources results in the overuse and exhaustion of the resource. Just look at the Atlantic fisheries, many forests in eastern Canada and Europe, and our current use of a clean environment. In this case, the role of the government is to appropriately price the good or service to prevent its exhaustion and to ensure that it can be appropriately managed sustainably. Thus, the role of taxation is to prevent or limit consumption, and then to utilize the revenues raised to either subsidize non-exhaustive alternatives or to fund the costs of managing the resource at risk. A great modern example of this would be the introduction and implementation of the carbon tax which both discourages consumption of carbon-intensive resources, funds the management of climate-sensitive areas and subsidizes alternative forms of non-exhaustive (“green”) goods.

High cost of Low taxes:

                With the basis of why the government collects taxes and provides the above-mentioned goods and services, what happens if the government fails to collect sufficient tax revenues? While hardly an exhaustive list, there are a few potential outcomes which have varying levels of social, and fiscal implications. Keep in mind, while I have said the following list is nowhere near exhaustive, it is also not mutually exclusive, many of these outcomes likely take place in mixed scenarios.

 Postponing of costs:

                Let’s start with the most straightforward of scenarios. To keep taxes low today, a government decides to postpone known costs. That is, they continue to provide current goods and services as listed above, but they neglect the amortized maintenance and replacement of these assets that will have to be funded in the future. For example, let's suppose that we could forecast that a new police station is needed for $500,000 in ten years. We could explore a few different scenarios.

a)       1) Put aside $X each budget cycle to save for this project.

b)       2) Keep taxes low today and wait till some future time to start saving.

c)       3) Wait till the end and debt finance the whole thing.

Let’s explore what this looks like in each scenario, if we presume a 5% prevailing interest rate, and presume we could get this same rate on our savings and borrowing, we face the following decisions based on when we start financing:

That is, as we can plainly see, every choice to keep taxes low today, by not putting money aside for known costs, results in a larger tax lift needed tomorrow, Further, this decision puts a higher burden on the taxpayer as each year postponed is a year where compound interest cannot be earned.

While the final option, to borrow, results in an annual tax lift between beginning to save in years three and five, the resulting burden to the taxpayer is the highest of all. If we make a further presumption, we can see the impact of each as a percentage increase to the budget. To keep things as realistic as possible let’s presume that we began with a million-dollar budget that, by default, will have to increase at 3% a year to cover inflationary and growth pressures. That being the case we can witness the resulting required tax lift (above the 3%) to finance this replacement in each case:

                Again, we can see in the final row added, that each year of postponement results in a drastic increase to the tax lift needed to meet this future obligation.

                Moral of this story? You can kick the can down the road to keep low tax rates for a while, but eventually, all bills come due!  Even if you decide to leave it and just borrow in the future, the tax burden is significantly higher than had you simply made the tough choice up front.

Cutting services:

                One of the other options that governments have to keep the taxes lower, would be to cut services. Keep in mind the services provided are typically done so as they satisfy a need that is unmet by the private market due to the nature of non-rivalrous and non-excludable goods.

                The choice to cut services is fine. It is ultimately society’s role to determine which services are desired and which are not. As we progress, grow and change, our demands and desires for services also grow and change. Thus, over time certain services that were once provided by the government may no longer be beneficial, while others that were never on the radar are now pressing.

                The issue with cutting services is ultimately similar to that of postponing costs. If you cut funding for services, despite a growing population, you are asking those who work in that field to do more with less. While initially this can be done for a time, it ultimately leads to staff burnout, fatigue, and inability to deliver on the mandate given.

                The result is often a failure or a near collapse of the system. We can see this currently in the aftermath of decades of service level cuts across much of the public service, but arguably most painfully felt in the fields of education and healthcare.

Suppose that budgets were cut by a half percent based on the argument that this would improve efficiency. While this might not seem like a large impact, after 5 years, an increase of 2.54% would be needed to return to the original funding amount, and after 10 years an increase of 5.14% would be needed. That is, while you might be able to cut taxes to put the squeeze on a certain department, the continued squeeze on a department requires a large single-period increase to return to baseline service levels in the case that this ‘efficiency’ is not found.

The tangential case of cutting services is not allowing services to expand. Suppose that the population and service demanded is increasing by a half percent a year. Rather than meeting this increased demand with increased staffing and resourcing each year, you would be required to make a 2.54% increase in 5 years and a 5.14% increase in 10 years simply to catch up to the underinvestment in staff and resourcing.

Again, the resulting message is either a small pain today or a large pain tomorrow if you decide to kick the can down the road.

Charging user fees:

                One way to lower the general taxation rate is to shift some of the burden of provision of services from being funded by general tax revenue, towards being funded either entirely or partly through user fees. The more things you can shift towards user fees the less you can charge in general taxes, but the more the households that utilize this service tend to pay as a proportion of their incomes.

The charging of user fees is an interesting economic case. On the one hand, if you can identify the individual who will benefit from the good or service, then they ought to pay for access to this benefit. Think of rec-centres and pools in this case. On the other hand, many of the goods and services provided by the government are provided due to the social benefit that they provide, and the charging of user fees acts as an additional per unit tax which typically adds to the regressivity of a tax system.

                There are many services provided by the government such that it is easily identifiable as to who is benefiting and thus able to charge them for access. From fire, police, education, public transportation infrastructure, recreation, sewer, garbage, water, I could go on. It is ultimately a policy choice whether or not to charge for any of these services through user fees.

                If the choice is made to not charge for these services, then we will tend towards over-utilizing, exhausting, or operating these resources over capacity – think of traffic on the highway partially due to no user fee, or wait times in the ER due to similar reasons.

                Alternatively, if the decision is made to charge for these services through a user fee, then the user fee in essence acts as a tax to access. As this tax is a flat rate ($10 to drop into the pool for example) then this user fee by definition would be regressive as a $10 fee is a larger proportion of income to someone who makes $500 a week versus someone who makes $1000 a week.

                Further, as the user fee is ultimately an optional tax (only pay it if you access it) the resulting social impacts are that those with lower incomes will tend to self-select out of these services, some of which are argued as vital for health and well-being.

                Thus, the choice to shift the tax burden from general tax revenue to user fees has the potential of adding to the regressive nature of taxation, predominately benefiting the higher-income earners while negatively affecting those who earn less.  

Privatization of services:

                To finish off this non-exhaustive list, let's look at the option of privatizing services. The idea of this was largely popularized with the rise of neo-liberalism and the move towards privatization of public assets seen worldwide but predominately championed by Margaret Thatcher in the UK and Ronald Reagan in the US.

The basic idea is that the private sector is more efficient than the public sector, thus if we privatize certain public services, these services will be able to be provided more cost-effectively.

While it may be true that the private sector can be more efficient, this is based on the assumption that the private sector is operating with high levels of competition. Many goods and services provided by governments are essentially monopolistic goods. Thus, the privatization of these lines of business provides a one-time boost to the budget as those assets are liquidated, but often results in long-term reduction in service levels and cost increases in line or greater than what may have been expected had it been kept in the public sphere.

Of course, this is not always the case – there are situations like the privatization of insurance in Alberta or the privatization of telecommunication where due to technological advancements competition was able to exist, thus driving a more efficient outcome than the government service. Unfortunately, however, more cases of privatization result in the privatization of a monopoly provider which we will continue to explore in this case.

Let’s presume that to keep taxes low today, the decision is made to privatize a certain line of public service that had a budget cost of $100,000. Again, if we keep things simple, for this to make sense the contracted provision of this service must be either the same or less than the current public provision cost. Let’s presume that the contractor can initially provide this service for $90,000 an instant savings of $10,000 as well as the positive cash flow from the sale of assets associated with this business line. Looks like a win.

Let’s look at some of the distributional effects. First, when this was provided publicly, it was typically provided by higher wage unionized workers, meaning that a larger proportion of this cost was going towards the labour force, those actually doing the work as well as the managers. When this is privatized and the service is now provided at a lower cost, the new entrepreneur has two options to turn a profit, either cut wages or cut service levels – typically both.

The result of the cutting of wages is a transfer of wealth from a distributed level between several workers into a concentrated level in the hands of the owner(s). Further, if possible, the reduction of service levels results in a lower provision per dollar spent by the public, thus society as a whole tends to lose while the few owners are the ones that tend to gain the most from the provision of a previously public service through privatization to a monopoly.

The outcome described above has been witnessed and played out time and time again. Without going into a full history of these events a brief look at the privatization of highway maintenance in Ontario, the privatization of prisons, the privatization of air ambulances and more highlight the frequent failures of privatization to monopoly providers.

The long-term effects of privatizing to a monopoly provider can be worse, in many ways binding governments to perpetual high-cost, low-service contracts. Many of these lines of business are monopolistic due to the extremely high capital cost of providing the service. As a result, there are often very few if any competing bids at each contract renewal. When this happens the monopolist provider knows that the government only has two options, accept their bid to provide the service or take the service back in-house.

This creates a moral hazard problem as the monopolist provider knows the huge capital cost that the government would have to face to bring this back in-house, and thus knows that the government cannot likely repatriate the service. Thus, knowing this, the monopolist provider has the majority of the power in the contract negotiation, able to push the terms of the contract renewal to be increasingly in their favour over the public or taxpayers’ favour, thus resulting in even higher costs to the public, higher levels of wealth concentration in the hands of the few owner(s) and lower levels of service.

There is significantly more research that exists on this topic, a fairly straightforward, non-technical, analysis of the failure of privatization can be found here, or an even easier read is this economist article that can be found here.

Conclusion and summary

                Throughout this post, I have aimed to justify why the government has a role in providing goods and services and how the government can attempt to provide these services equitably (trying to promote vertical and horizontal equity of taxation). Further, I discussed the problems due to pandering to an electorate by artificially keeping taxes low by postponing costs, cutting services, shifting costs from taxation to user fees, or privatizing these services altogether.

                While it is the policymaker's prerogative to undertake any of the above actions to provide a momentary reprieve in general taxation, the policymaker needs to recognize that any reprieve today will result in a higher cost tomorrow as demonstrated in each of the above cases.

                Thus, the primary role of the policy maker is to determine which services are to be the responsibility of their government and ensure through proper governance, oversight of management, and planning that these services are provided in the most effective way to promote the highest possible social benefit.

Unless a given good or service is now obsolete or is not capable of being provided through a truly competitive market, then any decision to postpone, or cut funding to an effective service today, will result in a higher cost tomorrow, thus we have our high cost of low taxes.

As always should you have any questions, thoughts or comments, please feel free to reach out or comment below!