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Energy Consumers vs. Regulators: Who Knows Best? (Mercatus study stands up to critics)

“Perhaps the main failure of rationality is that of the regulators themselves.”

-Ted Gayer and W. Kip Viscusi, authors, Overriding Consumer Preferences with Energy Regulations

In a working paper for the Mercatus Center titled Overriding Consumer Preferences with Energy Regulations, economists Ted Gayer and W. Kip Viscusi examine several energy use regulations and the accompanying Benefit-Cost Analyses (BCAs). They find the regulations would not pass a BCA (provide net benefits) without two assumptions: first, that individuals make systematic and financially significant mistakes in their energy consumption choices, and second, that government policies can correct these mistakes.

The regulations cited in the paper include mileage requirements for vehicles and energy efficiency standards for household appliances and light bulbs. The BCA numbers are telling – the authors show, for example, that the vast majority (about 85 percent) of the estimated benefits of the mileage requirements proposed in 2011 accrue to the individual user, mostly in the form of avoided fuel costs.

Without counting these private benefits (strictly counting avoided external costs, including CO2 emissions), the regulation would fail the BCA. That is, the regulations only make economic sense if we assume consumers behave irrationally when left to their own devices.

“Energy Efficiency Gap”

One type of irrationality discussed in the paper manifests as an energy efficiency gap, defined by some as “the difference between the actual level of energy efficiency and the higher level that would be cost-effective from the individual’s or firm’s point of view.” (International Energy Agency, 2007) The idea is that consumers neglect significant future energy savings by forgoing gainful investments in more energy-efficient cars, appliances, light bulbs, etc. According to proponents of the concept, consumers in such situations reveal irrationally high discount rates by their willingness to pay higher energy costs over the life of the product.

However, the authors criticize the concept of the energy efficiency gap on several levels, including the basic methodology for calculating the gap. ”Since the engineering studies focus only on capital costs and operating costs,” the authors find, “they do not allow for any heterogeneity of preferences and use of products across consumers.”

Market Knowledge

As previously discussed at Master Resource, the assertion that “bureaucrats know best” boils down to paternalism, not economic logic. Regulators cannot know the specific circumstances of individuals’ energy consumption choices or the individuals’ nuanced preferences. When a regulator mandates higher energy efficiency standards as a way to save consumers from their own bad decisions, the regulator is claiming to know information that he can never know, such as the consumer’s particular time preference at any given point and expectations of future use of the energy-consuming product, among other things. Economists and regulators alike should pause to consider once again Friedrich Hayek’s warning about the pretense of knowledge.

Further, even if we find that individual consumers do make mistakes, it does not follow that regulators and policymakers, who are also imperfect human beings, can remedy or even recognize those mistakes. As the authors point out:

Given the informational and analytical challenges of finding behavioral failings among heterogeneous individuals, this is a tall order for any analyst or policymaker, especially given that they are also prone to information and behavioral failings. A principal theme of Viscusi’s book, Rational Risk Policy, is that government regulators often institutionalize individual irrationality because policymakers are human and because the pressures exerted by their constituencies push policies in directions away from rational norms.

Or, as the authors put more succinctly later in the paper, “[p]erhaps the main failure of rationality is that of the regulators themselves.”

I’m reminded of the Law of the Instrument, as captured by psychologist Abraham Maslow’s quote, “I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.” Similarly, if you have a neo-Malthusian view of energy and natural resources (that energy and natural resources are finite and thus should be conserved), it is tempting to treat everything as if it were an over-consumption problem. However, the writers at Master Resource have dealt with this problem extensively (for example, here and here) and, in the spirit of Julian Simon, have shown it to be more fiction than fact – more pessimism than realism.

Sierra Club Criticism

Some critiques of the paper have been similarly off the mark. The Sierra Club recently issued a report titled Clean Energy Under Siege that stated:

The Mercatus challenge to appliance standards and efficiency generally seems to fall weakly away. The federal appliance standards program, signed into law by Ronald Reagan, has generally operated with the input and consent of the manufacturers…

The Sierra Club misses the Bootlegger-Baptist implications here. Large, existing manufacturers may actually favor energy efficiency standards for their anti-competitive effects. Simply put, following the letter of safety or energy efficiency regulations is easier for large companies, so large companies favor them as a way to keep their smaller (or newer, or not-yet-existing) competitors from entering the market. I doubt the Sierra Club would support cronyism unveiled, but it seems to be making no effort to lift the veil in this case. [1]

The Sierra Club paper also quotes an article written for the American Council for an Energy Efficient Economy that attempts to find flaws in Gayer and Viscusi’s paper. The ACEEE article states:

U.S. [appliance] standards reduced greenhouse gas emissions by about 200 million metric tons in 2010, and annual reductions will increase to about 450 million metric tons by 2025. That works out to about 3.5% of actual U.S. 2010 emissions and 8% of projected 2025 emissions.

Significantly, these figures ignore the basic question of whether those reductions make economic sense, which was the focus of the Gayer and Viscusi paper. The point emphasized by Gayer and Viscusi is that the environmental benefits alone do not justify the costs of energy efficiency standards.

To the point of reducing consumer choice, the ACEEE article commits the logical “post-hoc” fallacy, arguing:

…consumer choices have increased even as standards have eliminated energy-inefficient models from the market. Refrigerators come with a wider array of configurations, ice– and water-dispenser options, built-in designs, and other features, than have ever existed.

It’s impossible to know exactly what products we’re missing out on because of efficiency standards, but the Sierra Club’s and ACEEE’s response to the Gayer and Viscusi paper demonstrate a numbness to the idea of individual sovereignty. Why not let consumers and producers decide on their own?

Conclusion

In their working paper, Gayer and Viscusi demonstrate why it is problematic to replace the preferences of the consumer with those of the regulator and then deem the switch a societal benefit. Going even further, the very motivation behind conservationism and energy efficiency mandates is inherently unsound from the infinite-resources point of view, which the paper’s critics should take into consideration.

[1] Bruce Yandle, who first outlined the “Bootleggers and Baptists” theory of regulation, discusses this point with Russ Roberts in an EconTalk podcast (skip to the 46:30 mark).  A new report from the Mercatus Center also elaborates on the concept, which it labels “regulatory privilege.”

8 comments

1 rbradley { 08.06.12 at 9:07 am }

This is off-topic to this post, but MR contributor and solar executive David Bergeron posted at Steven Landsburg (“The Armchair Economist”) website: http://www.thebigquestions.com/2012/08/06/paging-diogenes/

2 Bob { 08.06.12 at 10:49 am }

It seems much to simplistic in assumptions, especially on the left/regulator side. Some consumers look at the real economics. Replace my ’05 Tahoe with a Volt? Assuming everything but price remains the same, the payout is ~8 years, if I pay cash for the Volt. Replace applicances with more energy efficient ones? Not until I remodel, it doesn’t pay to run out and get the latest and greatest. Us consumers might talk about energy efficiency but that’s just to buttress the decision to buy.

3 Jon Boone { 08.06.12 at 2:12 pm }

Thanks for posting this perceptive review. The Law of the Instrument is a good way to characterize policy mandated by those who think energy is a finite resource. Aside from benighted attempts over the years to regulate the performance efficiency of appliances, automobiles, and HVAC systems, the push in recent decades has been to improve the efficiency of electricity demand–as if electricity itself must be a scarce resource and demand should be externally controlled.

Nowhere is this pursuit more in evidence than with the push for “smart” meters. Consider reading this link for why smart meters are a dumb idea: http://www.consumersdigest.com/special-reports/why-smart-meters-might-be-a-dumb-idea/view-all. Note the oblique reference to the Baptists and Bootleggers routine.

4 Ed Reid { 08.06.12 at 4:46 pm }

In the case of appliances, the federally-required yellow labels have been around for a very long time. Consumers have the government-calculated annual operating cost estimates available to them. What the government fails to understand, or accept, is that their incremental installation cost estimates are often wildly inaccurate. Consumers are smart enough to add the higher cost of the appliance to the higher cost of the installation and divide by the difference in operating cost for the more efficient appliance. The payback period is very often longer than the anticipated life of the appliance. There should be little wonder that consumers are not “falling all over themselves” to choose the higher efficiency appliances.

Installation of a condensing gas furnace, for example, to replace an atmospherically vented gas furnace, requires the installation of a completely new combustion air delivery and exhaust gas venting system, which might be very expensive in a finished basement, or in a house built on a slab. Installation of a ground-coupled heat pump system might also be very expensive and disruptive on a landscaped property.

The performance levels required by the federal appliance efficiency standards have always lagged the commercial availability of appliances which were capable of meeting the new standards. The lowest efficiency appliances in a manufacturers product line typically have very thin profit margins, while the top-of-the-line appliances have substantially greater margins. That is fine while the potential for a good, better, best product line remains. However, over time, the “good” has been driven from the market, leaving only the “better” and the “best”. The “better” will be driven from the market next. Once there is no potential to differentiate products by performance, the only remaining options would be features and warranties.

It almost never makes sense to replace an existing, properly functioning appliance with a new, more efficient appliance from an economic standpoint, since the remaining useful life of the existing appliance becomes an economic dead loss.

Manufacturers have participated in the process to protect their interests. It is then “politic” to agree, especially when there is no other alternative. No business negotiation with government can ever involve “equal” parties.

5 Jon Boone { 08.06.12 at 6:44 pm }

Nicely put clarifying reflections, Ed, nuanced and articulate.

6 Travis Fisher: Energy Consumers vs. Regulators: Who Knows Best? (Mercatus study stands up to critics) | JunkScience.com { 08.07.12 at 12:45 am }

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7 Ed Reid { 08.07.12 at 1:49 pm }

Jon,

Thank you.

8 tfisher { 08.10.12 at 7:45 pm }

I just saw that Lynne Kiesling wrote about this paper too at the blog Knowledge Problem: http://knowledgeproblem.com/2012/08/10/gayer-viscusi-energy-efficiency-regulations-the-environment-and-consumer-sovereignty/

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