Some important topics: The oil premium and the rebound effect Economics 331b Spring

The Oil Premium 2

Sources of the Oil Premium Pollution (by air and other regulations) Congestion (generally ignored, but could use congestion pricing) Monopsony premium (pecuniary, affects oil expenditures)* Macroeconomic externality (inflation and unemployment in Keynesian world)* Global warming externality from CO2 (later in course)* Road safety (regulation, insurance, liability laws) Economic losses from disruptions (tough to estimate) Military costs (tough to estimate) * Covered today or later in the course. 3

Basic calculation of the premium The “oil premium” refers to the excess of the social marginal cost of oil consumption over the private marginal cost. Analytically, this is 4

The monopsony premium 5 5 Q(free market) P, MC of oil Imported oil S MSC Import premium at free-market imports “Optimal Tariff” at Optimized oil imports Q(“optimal”) D

Optimal tariff (monopsony) reasoning on oil taxes Basic argument. 1. The point is consumers have market power in the world oil market. By levying tariffs, consumers can change the terms of trade (oil prices) in their favor. 2. Regulation and taxes are a substitute for the optimum tariff. Simple reasoning: world supply curve to US: Q = Bp λ, λ>0; so p=kQ 1/λ US cost of imported oil = V(Q) = pQ = kQ (1+1/ λ) (k an irrelevant constant) marginal cost of imported oil = V’(Q) = (1+1/λ) kQ 1/ λ = p (1+1/ λ) So optimal ad valorem tariff is : τ = 1/ λ = inverse elasticity of supply of imports Reference: D. R. Bohi and W. D. Montgomery, “Social Cost of Imported Oil and UU Import Policy,” Annual Review of Energy, 1982, 7,

Optimal tariff argument (continued) Complications: This is oversimplified in bathtub model. Formula actually is 7

Optimal tariff argument (continued) Some notes: 1.Supply elasticity depends critically on whether oil market is at full capacity (2007 v. 2009). Very inelastic in full capacity short run; quite elastic when OPEC adjusts supply. 2.The optimal tariff in $ terms depends upon the initial price because it is an ad valorem tariff. 3.The externality is a global externality for consuming countries because it is a globalized market (in bathtub world). 4.Note this is a pecuniary, not a technological externality. So it is a zero-sum (or slightly negative-sum) game for the world. This has serious strategic implications and suggest that the diplomacy of the oil-price externality is completely different from true global public goods like global warming. 5.This does not have to be a tariff. It is really a “shadow price” on oil imports. 6.This is an example of “Ramsey tax theory” with inverse elasticity formula. 8

Price Production Short-run production capacity 9 The monopsony premium differs greatly depending upon the state of the world oil market.

Basics of deriving oil (monopsony) premium Here is a more rigorous proof of the oil-import premium: 10

Numerical example for US 11

Macroeconomic externality 12 Somewhat more tenuous is the macroeconomic externality. Idea is that there are impacts of changes in oil prices on macro economy because of inflexible wages and prices. So have another linkage: The second term was discussed in optimal tariff. The first term comes from macroeconomics (see next slide). This, however, is very controversial and the estimates are not robust.

Macroeconomic externality (cont) 13 Simplified derivation: We can also derive that monopsony/macro = ε[GDP/pQ] =.017*(15000/450) =.56

14 A standard macro/oil-price equation with “good” results. Macroeconomic externality (cont)

Updated estimates 15 Paul N. Leiby, “Estimating the Energy Security Benefits of Reduced U.S. Oil Imports,” ORNL, 2007.

Policies on Oil (Energy) Use Background –In general, first-best policy for reducing oil (energy) use is taxes on oil (energy). –However, because of “tax-aversion,” governments often substitute regulations. In this area, they are requirements on minimum energy efficiency –A standard question is their efficiency relative to fuel taxes. One specific case is: Do the induced effects of efficiency measures offset the direct effects and thereby lead to higher rather than lower energy consumption? The Rebound Effect 16

17 Rebound effect

Who are the players? Stanley Jevons: Introduced the idea that productivity improvements would lead to increased quantity because of price-elastic demand. Daniel Khazzoom: suggested that gains in energy efficiency would lead to less than proportional gains in energy use. Len Brookes: Energy regulation is completely ineffective because of rebound effect. Michael Grubb: Economists do not understand the profound inefficiency of energy markets. 18

Jevons paradox “The economy of labour effected by the introduction of new machinery throws labourers out of employment for the moment. But such is the increased demand for the cheapened products, that eventually the sphere of employment is greatly widened.” “The number of tons of coal used in any branch of industry is the product of the number of separate works, and the average number of tons consumed in each. Now, if the quantity of coal used in a blast-furnace be diminished in comparison with the yield, the profits of the trade will increase, new capital will be attracted, the price of pig-iron will fall, but the demand for it increase; and eventually the greater number of furnaces will more than make up for the diminished consumption of each.” Jevons, The Coal Question 19

The ineffectiveness of regulations “As we have seen, the enormous improvements in energy efficiency that have taken place have been accompanied by increases in energy consumption not decreases…” Len Brookes, Energy Policy,

The anti-rebound viewpoint “As many economists seem to have difficulty in understanding [why the rebound effect is minimal], it is worth reciting at least seven reasons for it: 1. Lack of knowledge, know-how and technical skills. 2. Separation of expenditure and benefit. 3. Limited capital, often arising from external restrictions on capital budgets. 4. Rapid payback requirements. 5. Structure of tariffs. 6. Lack of interest in peripheral operating costs. 7. Legal and administrative obstacles. [Therefore], policies aimed at removing or circumventing these market obstacles, and installing efficient, cost-effective technologies, will save energy and bring both environmental and economic benefits.” Grubb, “Energy efficiency and economic fallacies,” Energy Policy,

Rebound effects: categories 1. Direct rebound effect: Increased fuel efficiency lowers the cost of consumption, and hence increases the consumption of that good because of the substitution effect. 2. Indirect rebound effect: Through the income effect, decreased cost of the good enables increased household consumption of other goods and services, increasing the consumption of the resource embodied in those goods and services. 3. Economy wide effects: New technology creates new production possibilities in and increases economic growth. For small industries, #1 will dominate. #2 will almost always be too small to offset small #1. #3 is unclear about the mechanism that the authors are talking about. 22

Direct rebound effect… 23 G Price of vmt Before mpg improvement Gasoline consumption Effect of efficiency improvement “Rebound effect” After mpg improvement

… or maybe … 24 G Price of vmt Before mpg improvement Gasoline consumption Effect of efficiency improvement “Rebound effect” After mpg improvement

But welfare improvement is unambiguous 25 G Price of vmt Vmt Welfare improvement

Economics of direct rebound effect Assume that regulation increases energy efficiency of a capital good from mpg 0 to mpg 1. The question is whether the lower cost of a vmt (vehicle-mile traveled) would offset the lower cost. 26

Example of lighting: Did increased efficiency increase lighting use? 27

Example of lighting 28 Suggests that Jevons effect does not hold. Inelastic demand.

Empirical estimates of rebound effect for autos Basic results from many demand studies:* Short-run gasoline price-elasticity on vmt = (+0.06) Long-run gasoline price-elasticity on vmt = (+0.29) Therefore, the rebound would be 10 to 29 percent of mpg improvement. This can be applied to other areas as well. Reference: Phil Goodwin, Joyce Dargay And Mark Hanly, “Elasticities of Road Traffic and Fuel Consumption with Respect to Price and Income: A Review,” Transport Reviews, Vol. 24, No. 3, 275–292, May 2004, available at 29

30 Source: UK Energy Research Centre, The Rebound Effect

What about behavioral effects? This is largely an open question. 1.There are apparently major inefficiencies in energy use: -People overdiscount future energy gains -People don’t know the MPG of their cars -Example: people will pay $1 to avoid $2 in present value of future gasoline use. -Why??? 2. After almost 4 decades, we still don’t know -Why people have these inefficient patterns. -What to do to change them and to make people “energy smart.” 31