The Knowledge Problem
Commentary on Economics, Information and Human Action

Monday, July 15, 2002  

This three-article series on TechCentralStation (first article second article third article) connects the science behind renewables and technological change in energy to policy issues, much along the lines of my earlier post. And Sallie Baliunas is one of the most insightful and articulate physicists I've ever met (and my husband is a physicist, so that's pretty high praise!).

posted by lkkinetic | 7/15/2002 12:45:00 PM

WHY DOESN'T THE RECORDING INDUSTRY GET THIS? When Napster was active and we were all downloading songs like fiends, recording industry revenues and record sales went up. This Wired story from June reports on a recently released study indicating these results:

The Ipsos-Reid study found that 81 percent of music downloaders reported that their CD purchasing either remained the same or increased. That backs up research from Jupiter Media Metrix that concluded that people using file-sharing networks were more likely to spend money on music.

posted by lkkinetic | 7/15/2002 12:07:00 PM

OPTIMISM AND THE FUTURE OF ENERGY: Arnold Kling suggested that I explore the fuel cell future in more detail. I intend to delve further into the economics of such technological change, but for now, here's a compilation of several articles on fuel cell research and how close they are to economic viability. Most current analysts predict about 20 years. This October 1997 Wired story sets the stage by highlighting how hydrogen fuel cells work, what some of their limitations currently are (including cost per horsepower or kilowatt hour, and the infrastructure issue of hydrogen filling stations for fuel cell vehicles), and what kind of research is under way. The author also talks about one of my favorite public relations ploys in hydrogen fuel cells -- drinking the exhaust from the pipe. It's water, good old H2O. I heard a story last fall about BMW's prototype fuel cell sports car, and how they were doing a marketing gig in Los Angeles, at which Jay Leno took the car for a spin and then rehydrated from the tailpipe!

This July 2001 Wired story specifically addresses the prospect of fuel cells in transforming not just how we generate power, but how we organize the infrastructure of the entire energy network. The story focuses on the distributed resource research done at EPRI an electricity research consortium.

In recent years, a series of technological breakthroughs - and, more important, a critical mass of scientific ideas - has begun to coalesce around a new model for an energy system that would better serve the needs of the near future, while enabling power producers as well as consumers to lessen their impact on the environment in the long term. Both privately and publicly, many at the institute express concern that the policy thrust of the current administration will lock out the most promising set of innovations to emerge in the energy community since the creation of the existing grid in the first half of the 20th century. The end result, they fear, may be to freeze us into high-emissions power pathways for decades to come. ...

The smarter energy network of the future, EPRI believes, will incorporate a diversified pool of resources located closer to the consumer, pumping out low- or zero-emissions power in backyards, driveways, downscaled local power stations, and even in automobiles, while giving electricity users the option to become energy vendors. The front end of this new system will be managed by third-party "virtual utilities," which will bundle electricity, gas, Internet access, broadband entertainment, and other customized energy services. (This vision is reminiscent of Edison's original ambition for the industry, which was not to sell lightbulbs, but to create a network of technologies and services that provided illumination.)

This vision, which I share, promises to deliver a more robust and flexible energy network. It is also consistent with something I've been thinking more about and talking about with several industry folks -- a biological/ecosystem metaphor is a better model for a forward-looking, robust, flexible, efficient energy network than the traditionally mechanistic, engineering-focused model of an energy system. Engineering and mechanics are clearly important parts of creating and understanding a dynamic energy network, but we are likely to make some serious policy mistakes if we think only about them.

This abstract of a January/February 2002 Technology review article (access to full article available to subscribers) addresses the role of fuel cells in the electricity grid. It also makes a point that I have emphasized in my own work, although it doesn't make it explicitly: fuel cells and distributed generation will make electricity transmission contestable. That means that transmission will face potential competition, which will serve as a discipline on the transmission owner's ability to raise transmission prices, because if they raise prices consumers will be more likely to say, "thanks but no thanks, I'm going to buy and install a combined heat and power system for my production facility, so please take me off the grid." That's a much better way to discipline the pricing decisions of transmission owners than the traditional rate-of-return regulation that we've had for most of the past century, and in the past decade with stock market returns outpacing the regulated rate of return on transmission investment, has contributed to the dearth of grid network that we are confronting right now.

Now, the cool futuristic stuff: this March 2002 Wired story talks about thermoelelectrics -- using heat to generate electricity. This abstract of a November 2001 Technology Review article talks about methanol-powered fuel cells for cellphones -- 20 hours of portable talk time from methanol!!! How cool is that? This abstract of a January/February 2002 Technology Review article discusses how new plastics may contribute to making solar power more economically competitive with fossil fuel generation.

The big-picture punch line: our expectations of the future, including technological changes and how soon they are likely to become economically viable alternatives, are very important determinants of our current investment and consumption decisions. And current policy decisions can have large impacts, either positive, negative or mixed, on the future paths of these technological changes. But the problem is that these policy decisions are not made in a vacuum, nor are they made in an environment of certainty about the future. For all of these reasons, a lighter-handed, more flexible approach to energy regulation and energy policy is more likely to result in a robust, reliable, flexible, efficient energy network that behaves as well as a highly evolved natural system.

posted by lkkinetic | 7/15/2002 11:57:00 AM

WHY DOESN'T THE FCC JUST ESTABLISH SPECTRUM PROPERTY RIGHTS? This story is not a tale of a successful privatization program, but is instead a cautionary tale of how regulation has created a worse outcome than privatization could. Technological innovation is enabling us to use the radio spectrum more intensively than before. This innovation is placing pressure on regulation and property rights issues in the management and use of the radio spectrum. The current Federal Communications Commission (FCC) licensing system for spectrum, in which the government retains ownership rights to spectrum, is creating some conflicts and problems that would not arise in a privatized spectrum system. As a political process, it is also more prone to manipulation.

For most of the past century the federal government, usually through the FCC, has retained ownership of rights to transmit in various parts of the radio spectrum. For most of the twentieth century the FCC allocated spectrum use through either an application procedure or through a lottery; both of these allocation methods allowed the FCC to choose the potential licensees, in keeping with the FCC remit to govern broadcasts based on a public interest objective (this public interest remit for the FCC is increasingly coming into question, too).

As early as 1958, economists Ronald Coase and Arthur DeVany recommended privatizing the radio spectrum, selling it through an auction process. Privatization would create well-defined property rights in specific locations on the spectrum, and would enable spectrum owners to transfer rights, and importantly, to determine how much value they place on having adjacent owners far enough away to remove some, most, or all likely interference. Privatization could also involve a judicial system of legal recourse in the event that some owners believed that interference from someone else’s spectrum property harmed their use of their spectrum.

Since 1994 the FCC has auctioned spectrum transmission rights. The FCC retains ownership of the spectrum itself, but has been auctioning ten-year licenses conveying the rights to use spectrum for specific purposes. These licenses are not transferable between uses or between license holders. Retaining spectrum ownership enables the FCC to continue regulating broadcast, cable, telephone, wireless cable, and two-way analog and digital (such as analog and digital telephones and pagers) communication uses. However, a turgid system of enabling but regulating radio spectrum use, such as the FCC has been following since its inception, could slow or deter technological change itself, particularly in the burgeoning wireless technology industry.

New wireless devices such as Wi-Fi, Bluetooth, and HomeRF have become popular over the past year as people expand their network capability with wireless access through laptops, phones, PDAs, and other new wireless devices. These devices transmit in the 2.4 GHz (gigahertz) frequency, 2.4-2.483 GHz across short ranges. This portion of the spectrum is popular for several reasons, including the fact that the 2.4 GHz frequency is unlicensed. Thus regulatory hurdles in using this frequency are minimal relative to the other parts of the spectrum. Devices in this frequency also do not generate a lot of interference for each other because of the short ranges over which they transmit and because they generally operate as spread spectrum devices, which decreases the potential for interference. Customers have received a lot of value out of the increased use of this frequency, and these wireless devices have brought information access to many rural and underserved communities.

The 2.4 GHz frequency is right next to a licensed slice of spectrum; the FCC has licensed it to satellite radio operators. One of these satellite radio operators, Sirius, is concerned that consumers who use a mobile device in their cars will create interference over short distances with their satellite radio transmissions to those consumers, particularly in urban areas where buildings can create problems for satellite radio transmissions to automobiles. In a privatized spectrum system, Sirius and the device makers in the 2.4 GHz neighborhood could negotiate a mutually beneficial compromise; in the FCC regulated hybrid system we have now, though, Sirius has petitioned the FCC to force mobile devices in the 2.4 GHz frequency to operate at the lowest possible wattage, which is below the electric energy of the engine running the car. If the FCC grants this petition, the market value of wireless devices to consumers would probably fall.

Sirius appears to be using the regulatory process to increase the value of satellite radio to consumers. The Sirius and 2.4 GHz interference situation is an illustration of the wasteful incentives inherent in using regulation and the political process to mediate spectrum border disputes. Regulation creates incentives for companies to engage in expensive rent seeking. Privatization would favor uses of the radio spectrum that make the most sense for consumers, while regulation favors uses whose developers are better at manipulating the political process. The FCC’s continuing ownership and regulation of spectrum gives spectrum users an opportunity to use FCC petitions to mediate disputes instead of a judicial process based on law.

Because of the politics of spectrum rights and the lack of private spectrum ownership, resources might not get to move to higher-valued uses. The FCC is not going to be as impartial a rights arbiter as the combination of well-defined spectrum ownership and a court system using the rule of law. The absence of spectrum privatization may slow or deter potentially beneficial technological change, and leaves in place a political process more prone to financial and other manipulation than one based on markets and law.

posted by lkkinetic | 7/15/2002 10:53:00 AM

Thursday, July 11, 2002  

YES, I'M A BIT OF A FUTURIST OPTIMIST: Economically viable hydrogen fuel cells are coming. Not quickly, but they are coming. And that expectation of future applications of technological change should be causing the electricity industry to rethink the value propositions it is presenting to its customers, because it's going to become cheaper and easier for customers to say "we're outta here". This story, about the installation of a residential hydrogen fuel cell system in Georgia, illustrates the possibilities the future holds.

posted by lkkinetic | 7/11/2002 03:22:00 PM

More evidence that the OPEC cartel production ceiling is unsustainable collusion. From May to June, OPEC production increased by almost 100,000 barrels per day. Check out the table at the bottom of the article to see who was able to cheat, and by how much, according to these estimates from Platts. Furthermore, this Reuters story suggests that

... extra demand will be accompanied by a continued rise in supplies from nations independent of OPEC, leaving the cartel little room to manoeuvre in easing output restraints if it wants to keep oil prices near its $25 a barrel target.

"Economic recovery should be in full swing next year so we're projecting global demand growth of 1.3 million barrels a day," said Adam Sieminski of Deutsche Bank.

"But we expect non-OPEC growth of about 800,000 barrels a day and that will put a lot of pressure on Saudi Arabia to hold OPEC discipline together."

This article from yesterday's New York Newsday also discusses the changing mindset of Russia's energy entrepreneurs, seen through the lens of their evolving relationship with Iraq.

posted by lkkinetic | 7/11/2002 03:14:00 PM

FASHION LEADS THE WAY: Bravely diving into the breach, what what, Burberry goes ahead with its IPO. Investor confidence wavers today, but consumer confidence in a dynamic business with a well-defined and forward-looking brand and brand evolution persists! They offered at the low end of the estimated capital value of the company, which makes sense in this environment, but the road to capital markets is littered with many less-than-successful IPOs (like Donna Karan, which earned me a good capital loss tax deduction a couple of years ago; that's why I've moved to mutual funds entirely!). I'll be interested to see how long-lived their brand capital and their profitability are, and the corresponding share values.

posted by lkkinetic | 7/11/2002 12:31:00 PM

LINDOWS AND WAL-MART BRING CHOICE TO COMPUTER CUSTOMERS: An interesting story on National Public Radio this morning:

Lindows is a new computer operating system that's being sold with PC's for under $300. Its main selling point is its "click and run" application that allows users to easily download software. Although Microsoft and computer industry experts don't think Lindows and Windows are competing for the same market, Microsoft has taken Lindows to court complaining the names are far too similar. A judge has allowed it for now, pending a trial next year.

Lindows has been developed using the open-source Linux operating system by Michael Robertson, the entrepreneur who was behind He has paired with Wal-Mart to offer $300 personal computers with Lindows installed. The consumer goes home, fires up the computer, and can go to a site to download three free applications (i.e., spreadsheet, word processor, presentation program) that are Microsoft-compatible and are in a user-friendly graphical interface (GUI). The business model is that access to the software and upgrades comes with an annual subscription of $99. Robertson said that the interface is so simple that his 4-year old son, who can't read, can successfully download games and fire them up. The story does point out that the binding constraint on the success of this business model is the download speed for such software, given the 20% penetration of broadband. Another commentator in the story said that he doubts that Wal-Mart shoppers are the people who actively want operating system alternatives to Windows. Not only do I find this statement somewhat arrogant and condescending to Wal-Mart shoppers, who don't need to follow USDOJ v. Microsoft to know that Microsoft is everywhere, but it totally misses the point of where the value proposition is here for consumers, and how essential that proposition is to Schumpeter's perennial gale of creative destruction that keeps competitive pressure on companies like Microsoft. By partnering with Wal-Mart, whose business model has been the retailing sector's "killer app" for the past decade, and offering customers a low-price, user friendly product, customers don't have to think about or care about whose operating system it is, as long as the applications are interoperable and the entire integrated product works.

This is the beauty of entrepreneurship and the dynamic ways that market processes help unleash human ingeneuity. $300 computers at Wal-Mart. Life is so good.

posted by lkkinetic | 7/11/2002 11:22:00 AM

HAVIN' A HEAT WAVE: From the California newspapers, yesterday and today ... the LA Times describes the conditions leading to the first Stage 2 alert (when reserves go below 5%); the San Francisco Chronicle attributes the stress, at least in part, to a breakdown in conservation.

Today's LA Times story also points out the lower conservation than last June, and the importance of the 3,000 megawatts of additional (peaking) generation capacity in the state since May 2001. Not only does additional capacity stave off alerts and blackouts, it helps change the relationship between supply and demand in ways that keep prices lower and less volatile. The story in today's San Francisco Chronicle actually does a nice job of pointing out that in these heat waves, the price cap in the California market can become binding, and has encouraged power providers outside of the state not to offer power in the state, because they can't cover their costs at the capped price. Another simple, yet good, economic lesson: the people who benefit from price caps are the ones who can actually find a supply and purchase; the ones who are harmed by price caps are both the suppliers who have higher costs but would have supplied profitably at a market-clearing price, and the buyers who get foreclosed from buying because they can't find suppliers who can afford to produce at the price cap. Do California politicians who favor price caps realize that this policy harms buyers, which translates into harms for some of their voters?

Today's San Jose Mercury News story hits the same notes, including the unexpected outage of a plant in Southern California; the outage was due to a fan breaking, which is easier to distinguish from strategic witholding than the types of overuse outages that lots of peaking plants experienced in 2000 and 2001 (the distinction between engineering tolerance outages from overuse and "economic witholding" continues to be a major issue in the California electricity crisis post-mortem). Interestingly, the headline refers to the state's request to reduce electricity use, but nowhere in the article is there a single reference to the fact that big users used to have good price signal incentives to cut peak use, when they had direct access contracts with generators and had more ability to use metering and something approximating real-time pricing. But last fall the California PUC abolished direct access, unabashedly stating that the state needed large users to buy their power from the state's new power authority, because they had to earn revenue to pay for those high-price contracts signed in spring 2001. A few large users are on interruptible contracts, but that's a drop in the bucket. So now the only ways to get large users to cut back during peaks is to issue public pleas for conservation. Gee, you know, I think price signals to the large users would do the job a heck of a lot better, with less hand-wringing.

posted by lkkinetic | 7/11/2002 11:01:00 AM

I was going to spend some time today writing about the heat wave in the West, and how the California electricity network and "market" are responding to this first big stress in a very long time. Then I read Charles Oliver's outstanding editorial from yesterday on (link courtesy of Instapundit, thanks Glenn), and now I have some free time to think about other things! Charles' editorial reminds us that much of the ongoing sturm-und-drang in California's energy environment is the consequence of bad, highly politicized rules and policy decisions.

But it's important to remember that this activity [alleged generator manipulation of markets] didn't take place in a free market but in a highly regulated artificial market. State regulators designed that "market," set the rules and ran the exchange. They forced utilities to divest their own generating plants, and they kept the utilities from making long-term contracts. And they prevented new construction of power plants. The government set in place all of the conditions that led to a crisis.

California's energy crisis has given energy deregulation a black eye. But two dozen other states have also deregulated their power markets, and they haven't had the problems California has...

Other states didn't force utilities into state-run power exchanges. Instead, they left them free to buy power from whomever they wanted. That created competition and increased supplies and helped keep prices down. Pennsylvania started its deregulation program shortly after California "deregulated" its market. Pennsylvania has some 200 wholesale sellers of electricity. California had just 20.

Finally, other states generally did a better job than California at adding new generating capacity. They didn't wait for a crisis to start building new plants. They anticipated growing demand for new power. Texas alone has built 22 power plants since 1996 and has 15 more in the pipeline.

In short, these states gave more than lip service to deregulation. They actually cut red tape.

California officials want to blame the state's power woes on deregulation instead of their own misguided rules and regulations. It would be a shame if they were allowed to discredit a policy that has worked successfully elsewhere, a policy that they never really tried.

For those who still want to revisit the causes of last year's massive energy policy failure in California, here's the study that my colleague Adrian Moore and I did in January 2001 (one of the first thorough analyses of the situation, by the way), and here's the version of my study of other states and countries that the Texas Public Utility Commission republished in their consumer education efforts accompanying their deregulation.

The punch line: no U.S. state has really, truly deregulated the electricity industry. Even Texas and Pennsylvania, the jewels in the electricity restructuring crown, have retained retail price caps and other regulatory hangovers as part of the political bargain to get restructuring legislation passed (from the "half a loaf is better than none" school of political compromise). That said, though, they have done a far sight better at delivering efficiency gains and choice than could ever have been possible in the California regulatory environment. And they are continuing to push the envelope and apply an entrepreneurial, dynamic, open-minded perspective on the ability of competitive electricity markets to provide value and choices to consumers safely and reliably.

posted by lkkinetic | 7/11/2002 10:16:00 AM

Sunday, July 07, 2002  

In my relaxed perusals of the news this holiday weekend, I found two extremely good analyses by the typically good Amity Shlaes of the Financial Times. In her 27 June column she made a very important point about tipping in restaurants and a recent Supreme Court decision:

In the Fior d'Italia case, summed up on, the National Restaurant Association webpage, the IRS reviewed the restaurant's credit card receipts, finding a tipping rate that averaged a little over 14 per cent. Then it presumed the same rate on cash revenue, and concluded that workers had failed to report $304,000 in income for a two-year period. It charged the restaurant for back taxes of $23,262 (FICA of 7.65 per cent).

In its 6-3 ruling, the high court gave the IRS the authority to go after such unreported cash by estimating the amount of cash tips that go to employees.

She points out something very important -- the effect that this ruling will have at the margin on the quality of restaurant service. In her 1 July column, Shlaes pointed out another potentially detrimental unintended consequence of a legal/regulatory change, this time addressing the timely question of the accounting industry's ability to monitor its actions and enforce them without new legislation. Read both columns; they are good.

posted by lkkinetic | 7/07/2002 03:39:00 PM

The IAEE conference was very good -- lots of interesting papers, and I was fascinated by the similarities and the differences of the issues and approaches across this very international group of economists. In the next couple of days I'll be posting a summary of remarks from Lord Nigel Lawson, who was Chancellor of the Exchequer in Margaret Thatcher's administration. He gave a speech about electricity and natural gas privatization in Britain in the 1990s. I'll also highlight a couple of interesting papers and avenues of research about which I learned last week. But right now I'm off to Washington DC to teach some seminars.

posted by lkkinetic | 7/07/2002 03:32:00 PM

Wednesday, June 26, 2002  

I'm off to Aberdeen, the home of the UK oil industry. Can't wait!! I hope to find some good uisge beatha there as well; that's water of life, or whisky in English.

posted by lkkinetic | 6/26/2002 05:32:00 AM

OPEC's MEETING TODAY: Another variable in OPEC's ability to sustain cooperation in the cartel is something they will discuss today at their meeting: the fall of the US dollar. As this story reports, the currency in which oil trades are denominated us the US dollar, so its decline is not good news for oil producers who are trying to raise revenues from the sale of oil by restricting output to raise prices. As this story says,

Continued dollar weakness another incentive for OPEC members to bust quotas, OPEC source says. In the short-term, producers can maintain their purchasing power by selling more crude. The dollar recently traded at 27 month lows against the euro and at seven month lows against the yen.

This Bloomberg News story also summarizes the OPEC meeting, and mentions how much cheating on the production quotas is occurring, as well as the motivations for it:

Rather than raise the targets, members have pumped more than promised to fight Russia, Norway and other rivals for market share.

Isn't competition a grand, disciplining force?

posted by lkkinetic | 6/26/2002 05:31:00 AM

BRITISH EUPHEMISMS: One of the charming and fascinating things about British culture is the contradictory use of euphemisms for some things, and brutally frank phrasings for other things. The word "toilet" is one such contradiction -- whereas we Americans say "restroom" or "ladies room", even properly-brought-up Brits will say "excuse me, where is the toilet?" I must admit, this one grates on my ear much, much more than any other British/American English difference. So I was deeply amused yesterday when I encountered a reversal of this yesterday at Fortnum & Mason. I finally have done something I've wanted to do since I first studied in London in 1986 -- I had a cream tea service yesterday at Fortnum's (it was yummy, and the strawberries were fantastic, perfectly in season). I had some confusion following the waitress's directions to the ladies room, because when I did so all I saw was a door that said "ladies and gents cloakroom". Now, when I think cloakroom, I think coat check; but indeed at Fortnum's, the cloakroom is the restroom is the toilet!

posted by lkkinetic | 6/26/2002 05:24:00 AM

LONDON'S AIR QUALITY: I noticed something yesterday (Tuesday) that is quite different from the last several visits I made here, and from when I lived here four years ago. There are many, many more cyclists on the roads, and the cyclists no longer wear face masks to filter out the particulate in the air. London's air is still by no means pristine, as my skin indicates after just four days here, but it's quite a bit better than it used to be. Some of that improvement is due to fleet turnover, primarily in taxicabs but also a little in buses. Some of the improvement is also due to London's efforts to control congestion and use a fee-based system to reduce congestion in central London. I have not kept up with the developments in the congestion fee program, but I have noticed an appreciable change in air quality here.

posted by lkkinetic | 6/26/2002 05:18:00 AM

Monday, June 24, 2002  

THE HISTORY OF ECONOMIC GROWTH THROUGH CERAMICS, A STORY: I spent three-plus hours yesterday at the Victoria and Albert Museum, a monument to Victorian intellectual omnivorousness (and the grandeur of the Empire, of course). Most of this time I spent only in the ceramics and pottery galleries.

The evolution of ceramics uses, decoration, themes and techniques illustrates and parallels economic growth more broadly. The 12th-14th centuries were dominated by Islamic ceramics, which were largely mosque and palace decorations in very ornate, detailed geometric patterns. The dramatic colors of blue, orange/red and yellow were intense, and were the result of using costly vegetable dyes in great concentration. As with medieval cathedrals and castles in Europe, these decorations also functioned as a show of wealth. Increasingly over these two centuries these techniques showed up in home goods. Also increasingly into the 17th century, Islamic pottery showed strong use of Chinese motifs (especially as Ming dynasty pottery became so popular). The use of Chinese motifs also indicated the cross-cultural trade with China that increased up to the 17th century (but then fell off dramatically due to Chinese imperial isolationism), because the Islamic diaspora served as a crucial trade conduit between the Far East and Europe.

Spanish ceramics of the 15th-16th centuries reveal the Islamic influence of the Spanish conquest. Italian ceramics of the same period (15th-16th centuries) show many similarities -- the use of strong colors from expensive dyes, decoration of cathedrals and palaces -- but use largely religious themes (I believe the Koran prohibits human and landscape representations, so this difference is not that striking). The general appearance of Italian ceramics and the integration of geometric designs with human representations reflects an Islamic influence, certainly a result of cross-cultural trade and the growing trade networks of the Italian city-states. One thing I noticed yesterday is that around 1530 you start to see the Mannerist techniques of the Renaissance showing up in pottery, and the human representations become much more realistic and compelling, with more complex facial expressions.

Then the Dutch pottery becomes popular in the 15th-17th centuries, mirroring their growth and role as the commercial and financial juggernaut of the period. Again, Delft china shows a lot of Chinese themes, consistent with their trade and with the popularity of Ming china. Relative to the earlier Islamic, Spanish and Italian pottery, Dutch pottery is thinner and of a more consistent quality, which is the result of the increased ability to fuel hotter fires for kilns in reverberatory furnaces and clay-lined kilns to refract heat back into the kiln.

British pottery was, shall we say, rustic before the 17th century. Very utilitarian, with little emphasis on decoration and much on functionality. The heyday of British pottery comes with the entrepreneurship of Josiah Wedgewood in the mid-18th century, who harnessed the ever-increasing ability to fuel hotter and hotter fires more efficiently with coal and coke to build larger and larger kilns (that's economies of scale for you). He also spearheaded the canal construction of the mid- to late-18th century in the British midlands, which increased transportation networks for heavy and fragile items such as pottery (and, by the way, for coal and coke coming into Staffordshire).

Wedgewood and subsequent Staffordshire potteries, such as Minton, used these transportation networks and economies of scale in production to create consistent, higher quality, diversely decorated and styled, ceramic objects and vessels in a variety of price ranges. Now families in a wider range of incomes than just the wealthy with palaces and estates could have beautifully decorated, higher quality ceramic items to increase the beauty in their everyday lives. Mass production brought higher, and higher variety, quality at affordable prices for more people.

Mass production created a backlash, of course, in the Aesthetic and pre-Raphaelite movements of the late 19th century, with its focus on artisanal pottery. Mass production potters such as Minton cleverly incorporated these motifs as they became more popular, co-opting the arts and crafts motifs for mass consumption, but also thereby increasing their popularity (to this day, even; they are by far my favorite types of ceramics, especially in their American manifestations).

How does this story mirror economic growth? Look at the time periods of the ascendancy of each society's ceramics, the effects of cross-cultural trade on the aesthetics of a society, the effects of technological change on technique, the change in quality that provides increasing value for money for more people, and the role of entrepreneurship in creating growth and profit opportunities by serving wider and wider markets.

posted by lkkinetic | 6/24/2002 03:40:00 AM

OPEC AND VENEZUELA: An interesting story on the political dynamics of OPEC from today's (sorry, no specific link, I am reading the print version). At the upcoming meeting in Vienna, OPEC is expected to choose Alvaro Silva, Venezuela's current energy minister, as secretary general. The current secretary general, Ali Rodriguez, is Venezuelan, and Silva will serve out the remainder of Rodriguez's term. Hugo Chavez recalled Rodriguez after the failed coup against his regime to head PDVSA, the nationalized Venezuelan oil company.

This move is seen as a gambit to keep Venezuela from increasing its production; as I mentioned in a post last week, Venezuela shares Saudi Arabia's need for revenue from oil sales, and in the face of lagging demand worldwide, cheating on the production qoutas and increasing production may be the best way to achieve that. OPEC seems to believe that appointing Silva will undermine Venezuela's incentives to break with the cartel and cheat on its production quota. Silva is infamously anti-market, and opposed opening Venezuela's oil industry to foreign capital in the 1990s.

posted by lkkinetic | 6/24/2002 03:07:00 AM

MUNIS INVOLVED IN MARKET MANIPULATION? According to this Associated Press story and this Reuters story, a California Senate investigation has found email evidence that the Los Angeles Department of Water and Power, the largest municipal utility in the country, may have engaged in some of the same trading practices that have been called "market manipulation" when performed by independent generators. The role of the munis in the California "market" is potentially quite interesting, and the California Senate committe has been looking into it for the past year. The thing that I find the most striking is the completely inconsistent treatment and rhetoric between independent generators and the munis. Public power generators, such as LADWP and BC Hydro (from British Columbia), charged some of the highest hourly prices in the California "market" in late 2000 and early 2001, selling into the ISO in peak hours when the ISO was willing to pay almost anything to keep the juice flowing. My primary interest in this is that the actions of the independent generators and the actions of the munis should be treated consistently. If we're not going to castigate the munis for selling when the need was greatest and profiting from it, or for using arbitrage strategies that were legal (although potentially questionably ethical), then we shouldn't castigate the independent generators. And vice versa.

posted by lkkinetic | 6/24/2002 02:57:00 AM

Thursday, June 20, 2002  

OFF TO LONDON AND ABERDEEN: I am leaving tomorrow for London and Aberdeen, to give presentations at the Institute of Economic Affairs and the annual meetings of the International Association of Energy Economics. I am leaving town at the right time, as my Cubs continue to be depressing (although at least Alou's hitting is coming along, he just hit a single and is 2 for 4 today) and the first heat wave of the summer is coming this weekend. The paper I am presenting at the IAEE meetings is a version of this comment that I submitted to FERC in April in their market structure and design comment period, which I also mentioned below in my GAO post. I'm going to try to post commentaries on some of the papers, since it is an energy conference, as well as some observations as I travel around one of my favorite places on the planet.

posted by lkkinetic | 6/20/2002 04:38:00 PM

POSTREL ON MICROSOFT, JOSKOW AND TRANSACTION COSTS: Leave it to my eloquent former colleague Virginia Postrel to pick up on an extremely good analysis of the economics of antitrust law by Paul Joskow. I read this article on the plane to San Francisco last Friday, and it was one of the most compelling arguments I've seen yet for why actions, institutions and market structures that might look anti-competitive could really be outcomes of market processes. If you don't take into account transaction costs, you miss them. It's a great article. Virginia's column on it is also far, far better than any summary I could write; go read it and enjoy.

posted by lkkinetic | 6/20/2002 04:25:00 PM

HOW COOL IS THIS? Following up on an article in Monday's Wall Street Journal (subscription required), I've been reading up on Irbis Enterprises. Irbis, which means "snow leopard" in Mongolian, is an organization attempting to align the incentives of nomadic herders in Mongolia with not killing snow leopards to sell their coats. As the WSJ article says,

Irbis ... marries two causes -- wildlife conservation and poverty reduction -- that are often at odds ... [T]he snow leopard ... shares its home with people who have no option but to rely on the land for survival.

Here's how it works: Irbis trains nomadic herders in crafts using local materials. Herders sign a contract with Irbis stating that they will not kill snow leopards, and they keep the proceeds from the international sales of the items they make. Irbis pays each family a 20 percent bonus if no snow leopards are killed in their area, and if a snow leopard is killed, then all families in the area lose that bonus. This summary of Irbis' methods lays out the conservation contract and the bonus arrangement. Also, almost all of the individuals working with Irbis (and by association with the International Snow Leopard Trust) are indigenous Mongolians.

OK, how do the economics of this setup align incentives for human well-being with snow leopard conservation? First, Irbis is focusing on creating trust and relationships through developing local institutions, using local people and local knowledge. These informal institutions are the foundation of successful, ongoing commercial relations and trade. Second, the concept of a contract as a binding agreement between Irbis and the herders to trade skill acquisition and profits from crafts for profits from killing snow leopards creates an institution of visible commitment. Third, the payment of a bonus contingent on the actions of a larger group of families, and the potential loss of future profits from the cheating of any one family, decentralizes enforcement of this contract and creates a strong social norm within groups of herders to avoid killing snow leopards. Thus enforcement is cheaper and more effective because it relies on local personal relationships coupled with a potential real economic loss if any one of them cheats.

This set of institutions illustrates many, many of the lessons we learn from game theory. First, repeat the interactions to increase the possibility of cooperation to achieve mutually beneficial outcomes. Furthermore, exploit the already-existing repeated interactions among herding families that travel in groups together to increase the possibility of cooperation at lower enforcement costs. Second, find some way to make commitment credible, as Irbis is doing with their conservation contract and their trust-building activities. Third, use diffuse local knowledge to customize the institution to fit local culture and norms.

There are about 1,000 snow leopards in Mongolia, and none have been killed in the areas where Irbis has signed contracts with herders. Herder consumption of flour and rice has increased. Irbis is planning on expanding the program, which is quite young, into more of the snow leopard's range. This is very, very cool. Now if we could achieve this kind of institutional success with tiger (my favorite charismatic megafauna!) conservation and human well-being! This PERC policy analysis by Michael 't Sas-Rolfes illustrates only too painfully the incentive problems in wild tiger conservation, and how international treaties to end tiger poaching have little actual effect. The Hornocker Wildlife Institute sponsors and performs extensive conservation and habitat research on Siberian tigers, and you can sponsor individual wild tigers, but their program does not address the core incentive problems in tiger poaching in the way that the Irbis approach addresses the incentive problems in snow leopard killing.

posted by lkkinetic | 6/20/2002 10:44:00 AM

OIL MARKET ANALYSES: Two interesting stories today illustrate some very important points about how world oil markets are evolving. This Bloomberg News story describes how Russia and Norway are changing the dynamics of OPEC's ability to restrict output to raise prices:

Russia and Norway plan to end six months of output cuts and cooperation with the Organization of Petroleum Exporting Countries on July 1, increasing world supply at a time when demand is rising at half of normal levels. A drop in the U.S. dollar has weakened OPEC further, because its oil sales are priced in the currency.

Increasing non-OPEC production, the coincidental economic downturn of the past year, and the weakening dollar have all put tremendous pressure on OPEC's market share. The Bloomberg story concentrates on Saudi Arabia's need for revenue, which will keep it from being able to reduce output in the short run (aside: this pattern suggests that Russia and Norway increasing production makes demand more elastic, or more responsive to price changes -- a hallmark of increasing short-run competition). Apparently the price increase resulting from the reduced output over the past six months has not increased Saudi Arabia's oil revenue, and the country is thus in a pretty steep recession. The same incentives are keeping the oil flowing in Venezuela. Add to that the improving Russia-U.S. relations and the declining Saudi-U.S. relations, and you get a big change in the political economy of OPEC. The article also notes that

Russia is spending billions to rebuild its industry after the collapse of the Soviet Union. Russia in 1991 was the world's largest oil producer, pumping 9.3 million barrels a day, compared with 7.1 million a day last year.

Russia also is encroaching on traditional Saudi customers. AO Yukos Oil Co. has sent a cargo of Russian crude into the U.S., investigating the possibility of further sales.

This is a fundamental, and probably long-lasting, shift in the dynamics of the world oil market, as Joe Becker and I argued in a Harvard Caspian Studies Program Policy Brief published in April. As Brenda Shaffer, Research Director of the Caspian Studies Program, stated in her introduction to the publication,

Russia has emerged as the number two oil producer in the world market and its production share is estimated to continue to grow, especially due to the privatization of Russian oil companies. Russia's independent behavior in the oil market has caused a significant erosion in OPEC's monopoly power.

Second, this Chicago Tribune article today leads off with the implications of uncertainty in the Middle East for U.S. fuel price volatility. The article points out something that oil market analysts have seen for the past six to nine months -- a $5-6 per barrel "war premium" on crude oil prices that reflects the market risk associated with ongoing political tensions. The OPEC output restrictions of the past six months have also contributed to the price staying above $20 per barrel, but it has not had that much of an affect, as mentioned above. Still, crude prices have been hovering around $25 per barrel for several weeks, notwithstanding the seasonal move into increased summer demand and the variability of the political tensions in the Middle East. As mentioned in the Bloomberg article and this one, part of this price stability is due to the slow increase in U.S. demand because of slow economic recovery, and the tendency early in recoveries to focus on increased efficiency and doing more with less. The article provides this concise summary of the current state of affairs:

Three weeks into the summer driving season, a gallon of regular unleaded gasoline, at an average price of $1.38, is 22 cents cheaper than a year ago, according to the AAA Chicago Motor Club. Even in Chicago, which has had notorious gasoline price spikes for two summers running, a gallon of regular unleaded gas averages $1.56--20 cents less than last year at this time, AAA said.

Crude oil prices, a key component in the price of gasoline, are still being propped up by a war premium and by a tough output quota imposed by the Organization of Petroleum Exporting Countries. At Wednesday's OPEC meeting in Vienna, the 10 OPEC member countries with quotas in place are widely expected to extend their current export curbs through the third quarter.

What's the punch line? U.S. crude oil and gasoline inventories are pretty high in historical terms for early summer, the recovery is slow, so demand is increasing slowly and contributing to keeping prices stable and lower than last year. Another important factor in this dynamic is the 15 percent decline in jet fuel demand relative to the same time last year, which has meant that refiners have turned more crude into gasoline.

Finally, this article points out something important that often gets overlooked when we think about gasoline supplies: the production substitution between home heating oil and gasoline:

He [John Felmy, the American Petroleum Institute's chief economist] noted that a year ago the U.S. also was coming out of a very cold winter that had compelled refiners to produce more home heating oil, which put them behind in preparing supplies of gasoline in anticipation of the summer months.

This example illustrates just how complex the interaction is among all of the determinants of gasoline prices.

posted by lkkinetic | 6/20/2002 09:41:00 AM

Wednesday, June 19, 2002  

PAY TO CONSERVE, OR RAISE PRICES? Another Los Angeles Times story, State Energy Plan Offers Conservation Incentives, says that the California Power Authority will pay large industrial users to cut back their electricity use. According to the article,

The program will rely on satellite technology and real-time electric meters to dim air conditioners or lights automatically when the state's power buyers call on the companies.

My question is this: if they have this spiffy technology and can do the real-time metering, why not just free up regulation to allow utilities to offer a real-time pricing alternative to large industrial customers? Industrial consumers would face price incentives to conserve, and taxpayer money wouldn't have to fund it. We'd still get the benefits of reduced consumption and reduced construction of new power plants.

Severin Borenstein of the University of California Energy Institute has written extensively on this issue, including this article and this op-ed from the Los Angeles Times. He's right. Enabling consumer demand to respond to prices in real time would mean that prices would reflect the actual cost of providing us with power in that hour (yes, power costs fluctuate that frequently). More on real-time pricing later, but now I'm off to do some other work.

posted by lkkinetic | 6/19/2002 09:38:00 AM

GASOLINE PRICES RISE IN CALIFORNIA: This story (registration required) does a good job of illustrating how being so close to refinery capacity can contribute to gasoline price spikes. Although prices this summer are not high either historically or adjusted for inflation, they are exhibiting some of the usual "increase before driving holidays" pattern. The fact that refinery production is so close to total refining capacity means that any refinery outage could disrupt supply and lead to an unanticipated price spike. The article also does a nice job of pointing out that reformulated gasoline, as mandated by the EPA in areas with air quality problems, limits the extent of the market by making non-California gasoline less substitutable for California's reformulated gasoline. In the midwest we have enough different reformulations that we call this the "boutique fuels" problem, which contributed to the price spikes we saw in 2000 and 2001, but not this year (touch wood) because we have not had any refinery outages.

posted by lkkinetic | 6/19/2002 09:26:00 AM

Tuesday, June 18, 2002  

UPDATE: As you can see from the time stamp on this post, I was working way too late last night to remember that GAO is General Accounting Office, not Government Accounting Office. Apologies for the slip, which has been corrected below.

Well ... back from celebrating my birthday and my sister-in-law's graduation with my in-law family to ... a GAO report on FERC's ability to perform oversight functions in burgeoning wholesale electricity markets. No rest for the weary these days when it comes to energy policy.

On Monday the Senate Governmental Affairs Committee released a General Accounting Office (GAO) study that it had commissioned to explore the Federal Energy Regulatory Commission’s (FERC’s) oversight abilities. In general, the report found that FERC faces three substantial hurdles to overcome before it can provide the kind of straightforward, flexible regulatory environment consistent with enabling the evolution of a dynamic electricity industry.

The first hurdle is that FERC has a lot on its plate relative to its resources. FERC’s electricity jurisdiction, a relic of the old, vertically-integrated, regulated monopoly model, is ensuring that interstate sales and transmission prices in wholesale electricity markets are "just and reasonable," and the siting of interstate long-distance transmission lines. In the old "command-and-control" mindset, ensuring just and reasonable prices was pretty simple – cost plus a rate of return on the vertically-integrated utility’s rate base – and long-distance transmission was built for different purposes from transporting competitive generation. It was also not particularly technologically feasible to have economical long-distance transmission because of line loss. But now that the regulatory environment has changed, technology has changed, and business models have changed (and the report does a nice job of summarizing these effects over the past 25 years), the old model and its associated bureaucracy are not suited to a new business environment in the electricity industry.

At some level this conclusion is completely consistent with what both experience and theory tell us about regulatory institutions and market institutions. The major (and boy, are they major, as history has shown repeatedly) benefit of market institutions is that they harness human opportunism to create value through mutually beneficial exchange. That trait makes them flexible and quick to respond to changing environments and market conditions. Market institutions do not exist in a vacuum, though, as we have learned from the whole Enron/Andersen/energy trading experience of the past year. The rules underlying market institutions work best when they promote transparency and in most cases deter bad behavior, such as the exercise of market power. Market institutions where the rules provide transparency are self-correcting as long as they really are transparent and provide good information.

The major benefit of regulatory institutions is a level of stability and certainty in the absence of this combination of market processes and transparency-inducing institutions. One problem with regulatory institutions, though, is that they can harness human opportunism to create value for those with political power. More to the point of the GAO study, regulatory institutions can also get bogged down in bureaucratic processes and be very slow to anticipate changing environments and market conditions. Old procedures persist and are slow to change. The GAO report highlighted precisely this problem in its analysis of FERC’s obstacles – changing from a "command-and-control" regulator of a vertically-integrated industry to a more transparency-inducing , rule-simplifying regulatory institution that supports the web of formal and informal rules that create good market conditions.

FERC also has had a lot to prioritize – building more transmission to support competitive wholesale markets, wholesale market structure and design, and market oversight. In 1999 they chose to prioritize in that order, and only in the past six months have they gotten to working in earnest on the market structure item. In hindsight, if they could go back and change their decisions it is likely that they would have focused a bit more evenly among the three priorities, instead of taking them more sequentially. But, for FERC and for many of us, the important contribution of market oversight to transparency is something we are learning about as we go, and we can admit that if foresight were as good as hindsight, some of the electricity price spikes we have experienced (especially in California) could have been lessened somewhat. But asking humans to have perfect foresight is asking us to be something other than human.

FERC’s second hurdle, which the GAO called "daunting," is its human resources. Attracting energy market analysts would be difficult in any situation because of pay differentials between private sector and public sector labor markets, and these difficulties were exacerbated by the apparent (and looking more apparent and less real) energy trading opportunities of the late 1990s. FERC employees are largely grounded in the traditional regulatory model, a feature that contributes to the inertia and the status-quo path dependence mentioned above. Furthermore, many FERC employees are eligible to retire in the next few years, so now is a good opportunity to be strategic in hiring market analysts with human capital to bring to the market oversight function. FERC is also increasing its training and education activities, bringing in economists and market analysts to familiarize its staff with market processes and the dynamics of this changing industry. The GAO report recommends that FERC incorporate a strategic hiring and human capital management plan into its strategic plan.

The third hurdle highlighted in the GAO study is legislative. The kinds of civil penalties that, for example, the Securities and Exchange Commission (SEC) can bring to bear against rule violators are not part of FERC’s toolkit. Again, a relic of bureaucratic inertia – who needs civil penalties to regulate vertically-integrated government-granted monopolies? Which brings up an interesting thought: in all of the introspection accompanying the Enron/Andersen debacle, with the rethinking of the SEC’s enforcement, should we also in that process look for some lessons for FERC? I think so. Changing FERC’s enforcement toolkit is a job for Congress, and the GAO report recommends considering such a change.

The GAO report illustrates precisely the concern articulated in a comment that I submitted to FERC in April as part of their market structure and design rulemaking process. A possible consequence of setting up rigid institutions for regional transmission organizations is what economists call institutional path dependence, where institutions and procedures become entrenched through bureaucratic inertia. Thus one thing that FERC needs to watch out for that the GAO report and my comment both highlight is to beware of institutional change being just a ratchet to another locked-in set of regulatory institutions that are likely to become obsolete more quickly than not, and will almost certainly become obsolete more quickly than the existing regulatory institutions have.

This report is not an argument against competition and market processes in electricity, as many market foes and some of the commentaries I have read today would have you believe. Instead it is an argument for FERC to do the strategic planning and implement performance measures to create a set of regulatory institutions that rely on rules that encourage transparency, and focus on deterring the great majority of bad behavior.

The GAO report lacks something that I think is extremely important. It fails to point out that FERC was not to blame for the over-engineered, overtly politicized, dysfunctional rules that the state of California forced into laws governing its "market." FERC has admitted that in hindsight it would have changed some decisions, but California’s politicians have not been so introspective in public.

FERC is learning the importance of a balanced approach to improving transmission networks, creating rules governing wholesale market structure, and market oversight. This approach should use flexible regulatory institutions where necessary, and rely on market institutions and rules to create transparency and deter bad behavior wherever possible. FERC is also learning the importance of human capital in a dynamic, evolving industry. The GAO study is a constructive contribution to that process.

News stories from today on the report are here (registration required), here(registration required), here, and here. Depending on how the other items on my plate are doing tomorrow, I may say more about the divergence between the political rhetoric on this concerning the California situation and the more far-sighted nature of the GAO study.

posted by lkkinetic | 6/18/2002 10:19:00 PM
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