Part of what I love about economics is to apply economic reasoning to unconventional situations (the whole Freakonomics trend). So today as I was reading yet another article on BBC News about Somali pirates hijacking yet more boats around the Horn of Africa and tried to come up with a simple economic (versus political) solution. My solution is as follows:Basically, my idea is that you assign a property right to Somalia for an area of ocean and they can create a taxable shipping lane that is protected by either Somalia, or by a group of countries that are willing to take on the task. According to the Law and Economics movement, privatizing allows for externalities (pirates) to be internalized through higher prices (fee of passage). Though this would be increasing the price, the expected price should be the same.
Economic Analysis
Assume a probablility of being hijacked, 0.1%, and a cost associated if hijacking occurs, $5 million (includes loss of life, cargo, and naval costs incurred by supporting hijacked crews). Assume if hijacked, the shipper makes no profit. Therefore, the expected benefits are profits, $1 million. Further, assume shipping companies are risk averse.
Expected Utility = 0.99ln(1m) - 0.01ln(10m) = $13.52
Now assume the shippers have a choice, they can pass with uncertainty (above) or pass with certainty and pay a fee. Assume the fee is $110,000.
Expected Utility = ln(890,000) = $13.70
So we see that 13.70>13.52 and therefore it would raise the shipping company's utility to pay a fee.
*I use a utility function of natural log simply because we know this is a concave function which implies risk aversion. *
Essentially this is Adam Smith at work: division of labour. To enter the lane you pay a fee and for that fee you are guaranteed safe passage.
Right now the US government is saying that it is the responsibility of the shipping companies to protect their boats. This results in the shipping company having to take extra precautions to ensure that their cargo is safe through that area of the ocean. Why not divide the labour? Let an organization worry about protection, and let the shippers ship their cargo. I have no doubt that this could be a great commercial venture for Somalia - I'm sure they could use the money.
Unfortunately, to construct something such as this requires a stable, working government; something Somalia has been lacking since the early 90's. But Somalia does not have to be the acting force here; as I said above, it could be established by a group of nations that value safe waters. The prices could be set a break even so that shippers are not being excessively burdened and the revenue would be used to fight off those pesky pirates: problem solved.
Good job michelle and very interesting. The issue as i see it is that every country may decide to charge a tax. Who collects the tax and what is the penalty for not paying the tax assuming you can get through the area with out getting caught?
ReplyDeleteTHE CHEERLEADER
Theoretically, Somalia would be the 'owner' of the shipping lane which they would police and collect a fee for passage (just like Panama collects a fee for the canal).
ReplyDeleteAs I mentioned, Somalia doesn't have a recognized government at this time and has been in political turmoil for the past 18 years or so. That is why I suggested that an international governing body set up a shipping lane for which they would collect the fee. Every country could not charge a tax because they don't own the water or the lane. The group of countries that 'owned' the lane would police it, collect the fee, and if it were financially viable, split any profit that might occur (though I feel that it would be better as a zero-profit multi-government enterprise).
The issue of the boat going through the passage without payment is addressed in my economic analysis of the situation in which it is more cost effective (due to certainty of safe passage) for the boat to pay the tax than to take a chance getting hijacked (of course, my numbers are theoretical).
Michelle,
ReplyDeleteThanks for these posts. What a great site. (I was a econ major in college, and work on the confluence between econ and theology in my graduate work, so this is just wonderful to read).
Question, assuming such a shipping lane and tax are implemented, does this international-coop of countries also then assure and more importantly insure safe passage?
Jason
Thanks for the words of encouragement!
ReplyDeleteTheoretically, yes that is my idea. The shipping lane would generate revenue for its maintenance. The Panama Canal maintains its structure and waterways to assure safe passage and our shipping lane would assure against attack against pirates.
But you also said "insure" and that is something that I believe would not be cost beneficial to the coop of countries. But this does not mean that insurance against protection would be unavailable.
The Law and Economics movement suggests that the low cost insurer always pay the price to of wrongdoing, even if they are the victim. This sounds quite crazy but in fact it creates the correct incentives since the effects from the wrongdoing would not incur if insurance had been purchased.
With the creation of a safe shipping lane insurance companies would have an incentive to provide insurance to shippers who chose to take the shipping lane since undoubtedly there would still be a small risk of passage. As it stands, I don't believe there is an insurance policy for pirate attacks though I have not done research on this.
There is an issue which I didn't want to bring up in my post for fear of major backlash but the numbers that I used above are based on the assumption that national costs to rescue a ship belonging to a shipping company are internalized, i.e. the shipper would have to pay for the services of the US navy if a ship were to be hijacked. I don't know how this actually works but I'm supposing with high probability that the shipper does not internalize the costs of naval power. Hence, for this to work the costs of rescue must be internalized which would raise the expected costs of passage greatly.