In an age of growing awareness about climate change, unethical labor practices, and environmental degradation, consuming socially responsibly has become important to many individuals. Yet, despite the best intentions of many concerned consumers, markets can fail to translate these aspirations into sustainable outcomes. Brace yourself for an intricate story with a simple yet profound lesson.
The “dampening effect” of markets
At the heart of the issue lies, what recent SAFE research calls, the “dampening effect.” The effect is best illustrated with a theoretical argument. When socially responsible consumers reduce their consumption of a harmful good, for example, fuel, the initial effect is … well … a decline in the consumption of fuel. This is the direct effect, and it is not very surprising: some consumers reduce their consumption, and consumption in the market falls. So far, so good.
However, there is also an indirect effect. If some consumers reduce their consumption of fuel, this also lowers the fuel price, making the good more affordable and attractive to all consumers. This, in turn, leads to an increase in the demand for fuel. After all, even if all people share ethical concerns about burning fuel, they also like taking advantage of lower prices. This increase in demand partially offsets the initial reduction, which is thereby “dampened” in the market equilibrium.
Air travel is another good example. If an eco-conscious traveler avoids flights, airlines can lower fares and try to fill the open seats. Such lower prices attract other passengers and offset the initial demand reduction. As a result, the overall decline in flights — and emissions — is smaller than intended.
Effect also holds in large markets
A mathematical model shows that even markets with many socially responsible consumers are not immune to this effect if consumers consume more at lower prices. Importantly, the effect also holds on for single individuals in very large markets. Their effect on the price of a consumption good may be extremely small on average, but even this minimal price change matters because it affects the behavior of many, many other consumers in the market.
The result of the dampening effect is that reducing consumption to avoid its harmful consequences is partially offset by an increase in the consumption of others. This has two implications.
Consumers have an effect
Good news first. The dampening effect is only partial. This means that consumers do have an effect. Even in very large markets. This means that, if you value sustainability, you can meaningfully impact market outcomes by reducing harmful consumption.
But public policy is needed
Now, the bad news. The dampening effect exists and partially undermines the mitigation effort of individual consumers. This means that it is very difficult for consumers to solve the problem of harmful consumption themselves. Even if all consumers would like to reduce the harm caused by the external effects of their consumption, they won’t be able to realize their goals due to the dampening effect of markets.
This is why public policy is needed. One promising approach involves taxing harmful externalities, such as greenhouse gas emissions or pollution. These taxes can help internalize the social costs of production and consumption, creating incentives for businesses and consumers—be they socially responsible or not—to make more sustainable choices.
Unfortunately, individual countries are subject to a similar dampening problem. In the context of climate change, this is sometimes discussed under the label of carbon leakage: many strategies to reduce carbon emissions make it more attractive to emit more carbon dioxide in other countries. Hence, the mitigation effort of one country can be partially offset by other countries. Clever policies such as a carbon border adjustment mechanism can mitigate this problem. But the lesson is similar: reducing the harmful consequences of economic activity is best addressed with internationally coordinated institutional responses.
What do consumers think?
Do consumers anticipate the dampening effect of markets? A survey of 2,000 US consumers shows that many consumers, almost 4 in 10, expect a reduction in their own consumption to only partially translate into market outcomes. This belief is particularly pronounced for flights, where 6 in 10 consumers believe that, if they take less plane trips, their impact on the total number of plane trips is dampened. Every third consumer expects a dampening effect for a reduction of their fuel consumption.
However, more than 5 in 10 consumers do not follow the logic of the dampening effect. For example, they think that, if they reduce their consumption of fuel by 200 gallons a year, the total consumption of fuel also falls by 200 gallons a year. In theory, such optimism, even though likely mistaken, can encourage consumers to further reduce their harmful consumption. But optimism can also backfire …
Beware of cross-market effects
There is another twist to the story. Even the consumption of green goods can create harm if they are in limited supply (which is usually the case). For example, the supply of green electricity is fixed in the short run. Consuming more green electricity means that other consumers have to consume less green electricity. Partly, they will switch to brown electricity. So, consuming more green electricity is not environmentally neutral, but it can increase emissions in other parts of the economy. Consumers who do not understand such cross-market effects are prone to overconsume green goods. And when some consumers overconsume green goods, others are forced to rely more on brown goods, ultimately increasing overall emissions. In short, consumers who care about their impact do better if they consume even green goods in moderation.
The simple lesson
In the end, this intricate story has a simple lesson. Consumers’ impact is altered and often dampened by complex and difficult-to-understand market forces. Hence, individual consumers are not well-positioned to tackle the big ethical challenges of our time like climate change, environmental pollution, or animal welfare all by themselves, even when they have the best intentions. Instead, social responsibility requires effective institutional responses, such as increased taxes on harmful goods. A sound understanding of market mechanisms enables us to harness the market’s power to support, rather than undermine, our best intentions.
Peter Andre is an Assistant Professor for Behavioral Finance at SAFE.
Blog entries represent the authors‘ personal opinion and do not necessarily reflect the views of the Leibniz Institute for Financial Research SAFE or its staff.
