Free Market Incentives in the Oil Market: Too Little Too Late?

It seems increasingly important to hash out the debate over whether to let free-market forces resolve current energy issues.  The pro-market argument in regard to oil is straightforward:  as oil is depleted, limited supplies will send prices skyward and create incentives for the development of energy sources that are cleaner, more abundant, and closer to home.  The same high prices will motivate innovation in the transportation sector and dissuade consumers from buying gas guzzlers.

Arguments for intervention rest on openings for market failure.  The “hard path” of energy in the U.S. has brought us a small number of large providers.  Current gasoline prices don’t include the environmental costs of extracting oil, transporting it to refineries, refining it, transporting it to service stations, or burning it in engines.  Also omitted from prices at the pump are the external health costs of all these activities, the effects of global warming, and (hypothetically, of course!) the cost of wars related to oil.

Both sides acknowledge the general issues; we must confront specifics to decide whether market failure in the oil market warrants intervention.  Complexities abound—imperfect information itself clearly contributes to market failure here.  What follows is a partial list of externalities that would need to enter the cost-benefit calculus before efficient decisions would result.  How many consumers, students, or policymakers know the specifics?

The EPA reports that the combustion of a gallon of gasoline causes the release of 20 lbs of carbon dioxide.  Exhaust from petroleum-fueled engines also releases the following:

Particulate matter (PM).  Fine particles of carbon and an assortment of toxic acids, metals, and chemicals make up PM.  The particles are small enough to reach the deep recesses of our lungs.  Studies link PM with premature death, respiratory related hospital visits, aggravated asthma, acute respiratory symptoms including aggravated coughing and painful breathing, chronic bronchitis, decreased lung function, and work and school absences.

Volatile Organic Compounds (VOCs).  VOCs evaporate into the air and are present in one-fifth of U.S. water supplies.  VOCs can include acetaldehyde, acrolein, benzene, 1,3-butadiene, formaldehyde, naphthalene, and polycyclic aromatic hydrocarbons.  Some VOCs are known to cause cancer in humans.  Other health problems resulting from VOC exposure can include damage to the liver, kidney, and central nervous system; eye, nose, and throat irritation; headaches; nausea; and loss of coordination.

Sulfur Dioxide (SO2). Sulfur dioxide is emitted from diesel engines and coal-burning power plants.  SO2 is a cause of acid deposition.  Lifeless trees and lakes in formerly pristine areas of North America and Europe are among the results of acid deposition.  Acid also speeds the decay of buildings, paint, and many other exposed materials.

Carbon Monoxide (CO).  CO is a tasteless, colorless, odorless toxic gas, the breathing of which inhibits the blood’s ability to carry oxygen to vital organs including the heart and brain.  Depending on the level and length of exposure, CO can cause problems from dizziness to death.

Nitrogen Oxides (NOx). Exhaust from gasoline and diesel engines is the largest source of NOx emissions in the U.S.  NOx compounds are a source of particulates, acid deposition, strong acid aerosols, and ozone pollution.

Ozone (O3).  In sunlight, NOx, CO, unburned hydrocarbons, and evaporative emissions from gasoline react to form ground-level ozone, the principal component of smog.  The EPA describes O3 as a “potent irritant” that causes repertory problems and lung damage.

With gasoline at $3.00 a gallon, sales of larger SUVs are still brisk.  Would the same be true if price equaled social marginal cost?  The technology exists for solar panels on our homes to power electric cars in our garages, but current fossil fuel prices have done little to change the way we travel.  When I traveled overseas as a child I rode in a 747 that burned a gallon of fuel about every 280 yards.  When I took my own children overseas 35 years later the same type of plane carried us over the ocean. 

Rather than spurring progressive moves toward innovation, solar rooftops, public transportation, bike lanes, and biodiesel, the transportation market has hardly swayed from the status quo.  In some cases it has backpeddled.  In June the Ford Motor Co. abandoned it’s pledge to produce 250,000 hybrid-electric vehicles per year by the end of the decade.  The free-market responses have more to do with a fixation on oil, and include attempts to seek oil in the last pristine places.

Given the artificially low prices of fossil fuel and the severity of resulting problems, I believe that market solutions are too little too late.  Inadequate incentives for clean energy have ushered in inefficient levels of R&D, global climate change, ill health, environmental degredation, dependence on foreign suppliers, and unrest in oil-rich regions.

Free markets can work nicely in the absence of market power, imperfect information, and externalities, but in the energy market, the inconvenient truth is that we’re strapped with all of the above.

Dave Anderson
www.DavidAAnderson.com

Comments

[brix]

apologies for swinging at a strawman, but i don't see any reason why replacement energy sources for oil would be inherently cleaner. abundant, yes. close to home, probably. but cleaner? (think coal-to-liquids.)

[Bob H]

The other problem, an externality of a sort, is the extensive installed base we have utilizing those technologies. A fully depreciated refinery (or coal burning power plant) is that much cheaper than a new device that needs its capital investment worked down. This creates substantial inertia and thus prices need to be driven even higher to make the alternative energy source appear cost competitive.

[Chris B.]

It's worse than you make it out to be: fossil fuel use for transportation is not just insufficiently upwardly adjusted to reflect externalities, it's massively subsidised! When it comes to the public transportation and bike lanes that you mentioned, the market has nothing to do with it; it is the government (elected, to be fair) who spends money on six-lane highways instead of these things. Not that this is really a problem that markets could solve, since transportation infrastructure is pretty much the ultimate natural monopoly. I guess my point is that market imperfections in the Coasian sense aren't the only thing to blame; poor investments by our society--which would not necessarily have been different had the market been efficient--are also a huge factor.

[Dave A.]

Agreed--subsidies certainly play into the artificially low prices for oil. I'm told that the documentary "Who Killed My Electric Car" includes good discussions of manipulations of the transportation market by industry and government. Has anyone seen it?

[Duncan Brown]

Dave, Thanks for picking an important issue.

But I'm not sure what you mean by "artificially low prices for fossil fuels,"

"Current gasoline prices [you say] don’t include the environmental costs of extracting oil, transporting it to refineries, refining it, transporting it to service stations, or burning it in engines. Also omitted from prices at the pump are the external health costs of all these activities, the effects of global warming, and (hypothetically, of course!) the cost of wars related to oil."

In fact, prices do reflect many, if not all, of these costs. For example, drivers pay for removing removing sulfur from fuel (to reduce pollution); and the cost of protecting pipelines, tanks, and refineries form leaks. And it wouldn't be hard in principle to add a tax to represent the carbon emissions and other externalities.

I worry about the tendency of Congress to apply wanton pork barrel subsidies whenever they identify a new "crisis." Already they have laid massive distortions on the market in the forms of tax credits and production subsidies for corn-based ethanol and soy diesel; tax credits for hybrid cars, etc. etc. Subsidize science and engineering, not car companies and agribusiness!

[Enviro]

Brix: Right. That's part of the problem with free-market-only responses. Rather than aggressively seeking cleaner fuels as the pro-free argument suggests, the industry is going after ANWR, Antarctica, coal.

Duncan: I agree that we pay for various preventative measures (catalytic converers, filters, etc.). What we don't internalize as consumers are environmental costs (global climate change, acid deposition, extinction), health costs (asthma, cancer, death), political costs (war, disputes), and the like. That's my take on it. Others share your view that we internalize virtually everything. I know Steve Landsburg feels that way.

[Duncan Brown]

I don't think "we internalize nearly everything." I think we internalize many things, and most of the rest are internalizable with the right policies.

Some of the so-called externalities of oil use (like stupid wars in the Middle East) don't have anything to do with a free market approach. They are basically old-fashioned imperialism.

[Enviro]

Sorry--I misunderstood you. It sounds like we agree.

[Duncan Brown]

Fine. Thanks again.

[Eric H]

This is just Second Best theory with a list of scary chemicals piled on for rhetorical effect. You forgot to add dihydrogen monoxide.

Stipulating that a market failure exists, what is your point? I have a friend living in Germany right now who reports that he is paying the equivalent of about $6.20/gallon. That should be much closer to the marginal social cost, yet he is still driving a petrocar. Checking Ford's latest announcements, sales of SUVs are hardly "brisk", Prius and other fuel efficient vehicle sales are up, and stating the fuel efficiency of a 747 only with reference to distance and not passenger-distance seems intentionally misleading (BTW, my last few trips abroad have been on the more efficient 767, and Boeing has been putting it to Airbus with their far more efficient 7E7).

To say that the technology exists for solar panels to power electric cars in our garage is to trivialize a difficult problem. Yes, you can do it, but few could afford it, and it doesn't really do much for someone in Seattle when it's overcast, or Nome in the winter. That's not market failure; in fact, it seems remarkable that anyone is working on such products when a lower cost alternative already exists, quite the opposite of market failure. Regarding the demise of the electric car, please see David Friedman's post on the subject. And incidentally, have you ever looked at the process required to produce solar cells? It's not exactly environmentally benign. I also recommend Howard C. Hayden's Solar Fraud as a contrarian reference; whereas I believe that he overstates his case (sometimes by a lot), this physics professor does make points that require serious reflection (no pun intended) by anyone waiting for the solar utopia that has been promised since the 1970s.

And to say that an unfettered free market (a) exists and (b) is solely to blame is to promote ignorance of the legal chains that bind innovation in the automobile industry. As Arnold Kling points out,

[T]he biggest reason that Detroit has such a stranglehold on auto innovation is the regulatory structure that Washington set up, particularly in response to Ralph Nader. Today, I'll bet that it takes more lawyers than engineers to bring out a new car. Deregulate autombiles, and small, innovative companies will have a chance.

Most of the people reading this blog already understand these issues. We agree with much of your analysis. As to your recommendations, some are already converted, but the rest of us are tired and wary of intentionally misleading rhetoric that glosses over real problems in support of your personally favored intervention.

[Enviro]

What you'll see in Europe, Asia, and other places where gas prices are closer to the social marginal cost are much smaller and more efficient cars. I'm sure your friend in Germany will agree.

Your dismissal of my factual information as "a list of scary chemicals piled on for rhetorical effect" is reminiscent of paradies of Bush and his retreat from facts. The efficiency of the free-market models that the economists you reference embrace are reliant on full information, meaning that a necessary condition is that all the lists of scary chemicals are well known. It must also be known that even on an overcast day in Seattle, a solar panel will collect energy (my panel works great on cloudy days!), and that energy is storable and transferrable, so that locations with no wind, sun, water, etc., can still receive clean energy. Even geothermal heating/cooling systems can work virtually anywhere. Let's let the facts out rather than criticizing those who post them.

[Eric H]

Wow, a comparison to a “parad[y] [sic] of Bush” – isn’t that a little below the belt?

I’m not sure what you mean by "let the facts out rather than criticizing those who post them." As you may note on closer inspection, my entire comment was criticism of your factual errors and inappropriate use of rhetoric, not one statement about you personally. I not only didn’t dismiss but explicitly stated my agreement with your facts about pollution (I said, "Stipulating that a market failure exists ..." and "Most of the people reading this blog already understand these issues. We agree with much of your analysis"), so the premise on which you compared me to Bush is false. Your claims about David Friedman’s and Arnold Kling’s reliance on full information is both unsubstantiated and irrelevant, so not only did you fail to address the points for which I used them as reference, but your response does not even measure up to a good criticism of me or them.

My wife requests that I refrain from being argumentative, but I am still confused about the point of your post and wish to explain my reaction to it. I can only think of 3 possible intentions off the top of my head (denoted by (1), (2), and (3)): if it was (1) to provide a basic synopsis of the application of economics to automobiles for neophytes, then the discussion of the pollutants from cars is well placed. In fact, I would have thrown in both "noise" and "congestion". However, the subsequent statement about the "brisk" sales of SUVs, the oversimplification of solar power, and the misleading discussion of air travel set off alarms.

* Your next paragraph would require many paragraphs to unpack: suffice it to say that you inappropriately anthropomorphize "the free market", and your implication that biodiesel is unavailable – though I have made and purchased it myself – may have at least as much to do with technical problems, production cost, and regulation than with power or market failure.

* You felt the need to discuss VOC chemical names in detail, but assert that petroleum is artificially underpriced with no explanation – why? How do you know? By how much? That would be an interesting post. On the one hand, we know that taxes have generally exceeded profits in the past 20 years. On the other hand, the justification for those taxes is to build roads. On the other hand, only 1/3 to 2/3 of those road taxes actually make it to the roads. On the other hand (sheesh, 4 hands?), we know that the costs of security and the externalities listed as well as other costs are not included in the price. However, the latter would be at least partially offset by the former and some discussion of magnitude would seem to be consistent with alleviating imperfect information. Incidentally, I found that we have spent about $727 B total since 2003, and we consume approximately 146 B gallons of gasoline per year, so (727/3)/146 =~ $0.61 / gallon for Iraq. YMMV.

* You bundle in a claim of dependence on foreign supply of oil and other factors with other claims about externalities – why? Is foreign trade a new type of market failure?

* We learned from an article in The Economist last week that the world’s largest private reserve held by Exxon is only the 14th largest reserve when including state-owned oil companies. Isn’t that the opposite of a free market? You assert the existence of "market power" without any backing discussion – what do you mean by it? How do you measure it? Why didn’t it exist in 1998 when oil prices collapsed? Wouldn’t market power imply an artificially high price? Which dominates - the artificially lowness or the artificial scarcity-driven overpricing? And wouldn’t the fact that two of the larger petroleum companies – Shell and BP – have substantial investments in alternative energy suggest that any exercise of “market power” to keep solar down indicate a lack of self interest? That would be an interesting claim if you could substantiate it.

In other words, if this is still a primer, it has jumped too far, too fast. Add in the implication of the title, and it looks like you have done this:

1) Cars pollute. [True, but not interesting]
2) Pollution is an externality, a form of market failure. [True, but not interesting]
3) Not knowing the specific pollutants or their effects is another failure, that of imperfect information. [True, but irrelevant – having perfect knowledge of something that is external to the transaction does not change bargaining power ... or the fact that it is external]
4) If fuel were more expensive, people would drive more efficient cars [true, but only interesting in that you have left out the “all else being equal” caveat that I hinted at before and address below*]
5) ... [click the ellipses]
6) Markets in general have and will fail to deliver solutions to pollution, global warming, environmental devastation, disease, war, adequate investment in R&D, and foreign trade deficits. [controversial conclusion]

That appears to be (2) naked advocacy. In light of the last half of the post, I infer that the purpose of the chemical listing is not educational but rhetorical. It is sufficient to state that cars pollute; learning that exhaust contains 1,3-butadiene does not help one negotiate a better deal on transportation. Indeed, we still have a substantial imperfect information problem even after learning that: Where does it come from? Is it inherent in all petroleum-burning systems, or does it come from a particular grade (sweet/sour, heavy/light) of crude, a particular refining process, an additive (is the additive mandated?), or a particular type of engine? Does a technological solution exist? How concentrated is it? What is the mechanism by and threshold at which it harms humans? How serious and prevalent is that, especially in comparison with other potentially harmful substances, including natural sources? Because people hearing for the first time about carbon monoxide in exhaust might not understand that CO is an unstable molecule that devolves into CO2 relatively quickly, that CO kills within minutes, and that it is extremely unlikely that anyone has ever succumbed to CO fumes outdoors.

If your purpose is to teach, then I have no problem with the intent, only the execution (I think you should be more explicit in step 5). If your purpose is naked advocacy, then I have no problem with that, either, in principal. Either one by itself would be uninteresting for me and I would not have commented. However, this looks like (3) advocacy in the guise of pedagogy. One of the more enjoyable aspects of env-econ is that they either leave the advocacy behind or state it up front with a willingness to hear the other side. I object to this post if your aim is cloaked advocacy. As I said at the beginning of my last comment, it appears that you have latched onto a market failure (imperfect information) that is likely to be present in every transaction and thereby have a powerful justification for intervention wherever you decide to apply Second Best theory.

Your continued insistence on glossing over the costs and limitations of solar power only strengthens my suspicion that this is activism in the education’s clothing. An interesting exercise is to calculate the amount of energy in a tank of gas (Joules) and divide by refueling time (s) to get the equivalent power (J/s or W), and then compare this to the peak output of, say, Palo Verde. You will find that you can’t simultaneously recharge very many people on the grid at those rates. Therefore, you have to be able to spread the load out over a day. Using the grid introduces transmission loss problems and using existing nonrenewable power sources only moves the externality problem rather than eliminating it, so in a strictly renewable system, batteries ($) are a requirement, not an optional enhancement. Batteries are also a must-have when living in places with long stretches of cloudy days when the panels can’t perform near their peak output (ditto wind). Taking that into account and designing for reasonable system availability, you must either use a larger bank of batteries ($$) or a larger array of panels ($$) in Seattle than in, say, Albuquerque. Further, on the assumption that most rooftops in Seattle are neither flat nor South-facing, you will need either a tracker ($) or a substantially larger array ($). Without looking up the specifics and spreadsheeting it all out or factoring in the PV panel price rise that has occurred since the last time I did so, I would guesstimate that it would cost upwards of $100k for an installed system that lets you self-reliantly operate an electric vehicle in Seattle, in addition to the fact that you would have to give up the garage or a room or build a shed to house the batteries and equipment. So, yeah, the panel may work on cloudy days, but operating a vehicle charger every night, 365 days per year, is quite the expensive undertaking (had you followed the links from Ideas, you would have found a site that links to a short narrative on EV-1 charger options).

To put that into perspective, let’s say that the average American drives 15,000 miles per year in a car that gets 30 mpg. That means she uses 500 gallons of fuel per year. At that rate, and $3/gal, it would take almost 67 years to spend $100k on fuel. Or let’s use the $6.20 figure: it would still take 32 years. Considering the fact that the batteries have to be replaced every 2-15 years, and the PV panels every 10-30 years, it is not even close to economical to switch to solar (yet!), so unless you can substantiate a claim that $6.20 is still less than the social marginal cost, your search for a market failure to explain the lack of solar roofs continues. And we haven’t even factored in the cost of the fully electric car, which has been somewhere between the yet-to-be-produced Tesla at $100k and the discontinued EV-1 at $2.5 M (admittedly, probably not the marginal cost of production as discussed in the newsgroup discussion linked from the link given). Nor have we examined the by-products of solar system production at the scale required (lead, acid, scrap PV panels, silicon production, the effect of increasing demand on price, etc.).

Now, you may find fault with my back-of-the-envelope calculations, but this only gets at the tip of the iceberg you introduced. Let's "let the facts out": all of them, and nothing but.

* There are still plenty of non-electric, large D-B and Italian sports cars and other vehicles in Germany that drive uneconomically fast, so apparently something else is keeping people from making the choices you think they should make. In the interest of curing imperfect information, I would like to know what else is going on. May I suggest that - to the typical consumer - a car is not simply an efficient system to get one person from one place to another? For some people, an SUV might actually be the best choice as gasoline prices go higher if signalling is important.

[Dave]

Eric,

Thanks for helping to hash these issues out. We obviously see a lot of things differently, and that's healthy. The crux of our differences may lie in your acceptance of the market failure (your items 2 and 3, which you say are "true") and yet your characterization of the conclusion that markets fail to yield efficient outcomes (your item 6) as controversial. This, to me, is the interesting part of the conversation. What, in your view, prevents (2 & 3) from implying (6)? Usually I see the market failure information dismissed, which is why I elaborated on the sources of failure. You seem to accept the sources but dismiss the failure. Have I misunderstood your argument?

Dave

[Eric H]

If you want to say, "Market failures exist in this market, therefore this market is inefficient," I can agree with that. If you want to say, "Market failures exist in this market, therefore markets have and will always fail," or "Market failures exist in this market, therefore markets cannot deliver solutions", I think that is a compositional fallacy and an overstatement.

If you want to say, "I spy a market failure, therefore there can be no free market solution in this market," I am going to have a problem with that, too. First, I doubt whether there are very many markets that don't have at least one type of failure present, so intervention can almost always be justified on the slightest pretext. Unfortunately, most seem to stop their analysis at that point without looking at the inefficiencies introduced by the recommended intervention. The market may not provide a perfect solution, but the best intervention may actually be a third-best solution to a secondary market solution. Radio, which seems to fit the definition of a public good, seems to work pretty well with the inclusion of commercials.

Second, I think knowledge failures are at least questionable for several reasons. I've read that imperfect information is a cornerstone of Austrian theory and that Vernon Smith's work shows that markets perform amazingly well despite knowledge gaps. Buyers and sellers almost always possess information the other does not. Akerloff would have us believe that a market in used cars can't exist; and yet it does. Markets are also amazingly adept at providing solutions to market failures: Carfax, OU, and CU, for example.

Third, when a market suffers from multiple failures, they don't add only in one direction; they frequently cancel one another. The state ownership of oil and the corresponding ease with which OPEC should be able to cartelize should raise the price, while externalities imply an artificially low price - which dominates? We know that the cost of our interventions in oil-producing regions is not accounted for in the price, but the risk premium brought about by the unstable regimes and regions that happen to possess the oil and our interventions in them is. Now add Hotelling into the calculus, and figure that the cartel members are going to cheat to drive prices downward, while federal taxes and regulations (not all of which are rational or efficient) raise the price.

Fourth, "the free market" is not a monolithic organization with a common goal. Toyota is killing GM and Ford with its high efficiency lineup - does anyone truly believe they won't respond? If they don't and fail, are we worse off (less competition) or better off (the better product and organization takes market share)? BlueSun, Piedmont Fuels, Yokayo and other dealers are trying to make a go of biodiesel, and the current high price environment makes them the low cost producer. Incidentally, I can't resist pointing out that you can't buy a new diesel in any state that has adopted CARB, so a grey market in used diesels has sprung up (a market response to a failure caused by intervention!).

To summarize, I only think you overstated your case and piled on a lot of supporting statements that are - if not wrong - at least disputable and potentially distorting. Take it in smaller bites and I think you will find that we mostly agree.

For my part, I am concerned about the Red Queen gambit that any solution - market or government - seems to imply. That is, employing technology to run as fast as we can just to stay in place. I think future success is going to require not just technology, but wiser use of it. As an example, I cite the Freecycle organization, which uses the internet (high tech) to recycle used stuff (low tech). Though I have my problems with some of his ideas, Amory Lovins seems to have taken this approach. He gets a MacArthur award while Julian Simon gets dismissed for pretty much the same thing (Lovins is a better self-promoter, Simon was a better empiricist). Have you read The Oil Endgame? Some of their conclusions are Pollyanaish, but you can't just dismiss the arguments out of hand (and it's free!).

I also find it curious that people who are pro-Coasian with respect to SO2, for example, are anti-Kyoto, while pro-Kyotists seem to be anti-Coase on principal. There is a case to be made for the former reaction since Kyoto does have some problems in the details, but they seem to be against it on principal. The latter group will react with horror if you suggest regulating pollutants by markets (you should just BAN THEM!!!), yet that is the foundation for Kyoto. You need look no further than the comments on this blog and other places regarding second hand tobacco smoke for proof.

[Enviro]

Nice post. I agree that we mostly agree.

Cheers,

Dave

www.DavidAAnderson.com

[Concerned Student]

Hi I dont know if anyone of you people can help me out on my economics paper that is due tommorw!! I dont understand the following and what they are sking. It would be great if someone could some up what they are sying.
_Relate how free market emphasizes the incentives involved in peoples desicon making.
_Be specific were these soulutions have been implemented and how they are working.
Thank you! Concerned Student