The Knowledge Problem
Commentary on Economics, Information and Human Action

Wednesday, October 30, 2002  

A BOOK RECOMMENDATION: My dissertation advisor and long-time friend, Joel Mokyr, has written a new book that will be published in December. Titled Gifts of Athena: Historical Origins of the Knowledge Economy, it is an historical analysis of the relationship between economic growth and access to information on technological change and new ideas more broadly construed. From the book description:

He argues that the growth explosion in the modern West in the past two centuries was driven not just by the appearance of new technological ideas but also by the improved access to these ideas in society at large--as made possible by social networks comprising universities, publishers, professional sciences, and kindred institutions. Through a wealth of historical evidence set in clear and lively prose, he shows that changes in the intellectual and social environment and the institutional background in which knowledge was generated and disseminated brought about the Industrial Revolution, followed by sustained economic growth and continuing technological change.

Joel is an intellectual omnivore with wide-ranging interests, and the erudition of his writing makes his work even more compelling. And he's willing to be controversial, so you'll think when you read this. Read it and enjoy.

posted by lkkinetic | 10/30/2002 09:29:00 AM

CATCHING UP ON MY READING: Okay, I'm way behind in many things because so much is happening in electricity. In catching up on my reading I found some great comments by Will Wilkinson, whom I had the good fortune of meeting recently. Note especially his posts on Steven Pinker's new book and why he is a Whig. In fact, my father and I have each referred to ourselves as Whigs for the same reasons as Will (and Ken Binmore, who Will cites), so I chuckled when I read it.

posted by lkkinetic | 10/30/2002 08:50:00 AM

ECONOMIC HISTORY AND THE RATE OF CHANGE: Brad DeLong has an article in the November issue of Wired that puts our rates of technological change in historical perspective. An excerpt:

Past industrial revolutions — steel, for example, or the coming of mass production to the automobile — had seen explosions of technology that drove the prices of key commodities (train rails, the Model T) down by 5 to 10 percent a year for one, two, or three decades. The information age is not your father’s Oldsmobile: The price of computation, according to Yale’s Bill Nordhaus, has dropped 42 percent per year over 60 years — a trillion-fold fall since 1940.

Today’s technological revolution has so far lasted between two and six times as long as previous revolutions. It is between five and ten times as fast, a race between a cheetah and a possum. And it is a larger share of the economy. It changes what people do in their work, where it is done, and even what economic activity is. The problem: We are not sure how. (Spare a thought for Alan Greenspan — negotiating a soft landing is even harder when you don’t know where the statistical ground is.)

We are not sure how. Yet another sense in which the market process is one of discovery, and a very diffuse one at that. Drives the central planners nuts, heh heh.

posted by lkkinetic | 10/30/2002 08:43:00 AM

Tuesday, October 29, 2002  

HOW APPALLING IS THIS? According to John Fund's Political Diary on today, California Governor Gray Davis showed his temper in a most appalling and embarrassing way on Friday 18 October. His outburst was prompted by a professor's attempt to initiate a conversation about an editorial about electricity pricing in California written two days earlier by Vernon Smith, recent Nobel laureate. has reprinted Smith's article today.

All Ely Dahan wanted was a brief conversation with California's Gov. Gray Davis of California about an exciting article by a Nobel Prize winner that had just appeared in The Wall Street Journal. Mr. Dahan, a UCLA business professor, thought the article had valuable insights into California's electricity problems. What he got instead was a highly agitated governor ignoring the policy points, cursing the Journal as "f---ing a--h---s," and declaring: "They don't see the world realistically." End of conversation. ...

Mr. Dahan's encounter with Mr. Davis came on Friday, Oct. 18, after the governor had finished a taping of CNN's "Moneyline," hosted by Lou Dobbs. Prof. Dahan approached the governor along with several students. Mr. Dahan wanted to discuss an article he had just read in the Oct. 16 Wall Street Journal by Vernon Smith, a George Mason University professor who the week before had been one of two winners of the Nobel Prize in Economics. The article, "Power to the People," explained how California could take advantage of the fact that the cost of producing electricity can vary along with its pricing. California's energy crisis was born because of a state rule imposing on utilities an "obligation to serve" all customers "could not be met at times of severe stress because the unresponsive demand exceeded energy supply, and the shortfall was met by rolling blackouts." California utilities lost some $14 billion trying to avoid those blackouts. A small fraction of that would have solved the problem if utilities had been allowed to "sell less to consumers by offering a discount if they consumed less."

Read the rest for yourself. Davis' anti-intellectual lack of willingness to engage with ideas in the electricity policy process indicates a lot about him. I hope Davis has the dignity to be embarrassed about his outburst. But I doubt it.

posted by lkkinetic | 10/29/2002 04:31:00 PM

CALIFORNIA ISO FINDING AGAINST CALIFORNIA PUC'S FINDING: According to Energy Online Daily News article, the California Independent System Operator found that Duke Energy did not withold energy and cause a blackout on 8 May 2001. This ISO investigation was in response to an earlier California PUC report, on which I commented extensively (and critically) in this post.

posted by lkkinetic | 10/29/2002 07:23:00 AM

Monday, October 28, 2002  

MORE ON OIL AND IRAQ: Some more good articles have come out in the past couple of days on the prospects for the oil industry of regime change in Iraq, including this LA Times article exploring whether regime change would weaken OPEC. The experts interviewed have mixed opinions on whether Iraq would leave OPEC under a new regime, but all agree that more capital investment in the industry in Iraq would change the dynamic of OPEC. OPEC is in difficult straits at the moment, and is unlikely to be able to sustain the current high prices, as the closing comment in this article notes:

"OPEC faces problems not just from Iraq," said Petroleum Finance Co.'s Alkadiri. "Global demand isn't increasing that rapidly. You have a lot of non-OPEC production coming on. Within OPEC, you have countries that are well over their production quotas. You have a whole bunch of problems that point to a struggle within the organization and, ultimately, to the unsustainability of present prices."

An article in Saturday's New York Times examines the prospects for the oil service sector of the industry, which could see a lot of work from rehabilitating Iraq's derelict oil fields. The article refers to a Deutsche Bank analysis by Adam Sieminski, one of the best energy analysts around, that points out the agreements between Iraq, Russia and France in the past decade:

Over the last several years, Mr. Hussein has signed memorandums of understanding with oil companies to develop fields once sanctions are lifted. With the United States and Britain most sharply at odds with Mr. Hussein, American companies and BP did not participate in the process. Mr. Hussein himself favored companies from France, Russia and China — in an effort, Mr. Sieminski said, to win friends in the United Nations Security Council.

There is debate in the industry about whether those agreements will be honored once sanctions are lifted, Mr. Sieminski said. If Mr. Hussein remains, the memorandums would probably remain valid. But if he goes, there would most likely be a great deal of jockeying to develop fields that hold billions of barrels of oil, industry experts said.

This history makes the whole issue of "regime change in Iraq is about oil" very, very complicated. Have Russia and France been entering agreements with Iraq that violate the spirit of the UN sanctions? How likely is it that they would not be able to invest in Iraq? I would bet that these kind of considerations are influencing their attitudes toward regime change. Much of exploration and capital investment in the oil industry these days is done through multinational partnerships, and Russia and France would like to ensure that their oil companies can participate in such partnerships; Nick Schulz of Tech Central Station made this point in a National Review online commentary in September, and it's very important. A negative spin on this point, though, would be that regime change in Iraq could remove Russian and French oil companies from their preferential relationships with Iraqi leadership, feeding into Russia and France not supporting regime change. I don't think this negative spin makes sense, because having preferential treatment in an environment with decrepit capital assets, UN sanctions, and other obstacles to trade really cuts the prospects for profitability in Russia's and France's slice of the pie.

The truly beautiful thing about free trade and investment is that the size of the pie increases, so even if you have a small slice you end up with more than you had before. The richness and potential of Iraq's human capital and oil assets are a growth opportunity for Iraqis and for multinational consortial of oil and oil service companies to work in collaboration with them to create value that does not currently exist. So there's room for persuading Russian and French oil companies that a modern Iraq will benefit them, in addition to the benefit for Iraqis of modernity (to use Tom Friedman's language, which I like in this case).

posted by lkkinetic | 10/28/2002 09:36:00 AM

Wednesday, October 23, 2002  

TURMOIL IN THE BRITISH ELECTRICITY INDUSTRY: Here and here are a couple of articles, from different perspectives, analyzing the decline in profitability in the British electricity industry over the past year. The past year has seen both a regulatory change in Britain and a decline in electricity prices, and several companies are not faring well in this economic environment. The credit crisis in the US has spilled over into this, too; one of the companies having trouble in Britain is TXU, the very beleaguered energy company that has had to sell much of its European capital to repay debt. Ugh.

posted by lkkinetic | 10/23/2002 06:30:00 PM

CO2 EMISSIONS TRADING, THE COASE THEOREM, AND CREATING NEW MARKETS: In many ways the jury is still out on the science of climate change, from clouds to carbon sinks to the magnitude and geographic incidence of likely effects. Notwithstanding those uncertainties, the political reality is that controlling greenhouse gases is getting more and more attention, and the possibility of government regulation at several levels looms.

Enter Richard Sandor and his colleagues at Environmental Financial Products in Chicago. Sandor is an economist and a market-creating entrepreneur, who has spearheaded the creation of markets for interest rate derivatives and for sulfur dioxide emissions in the past three decades. In a collaborative effort among many stakeholders, Sandor is leading the creation of a market for carbon dioxide emissions. This market, called the Chicago Climate Exchange, is the product of bringing together firms, consumers, government representatives, and advisors to determine the parameters and rules of the market.

The motivating principle behind creating emissions markets is the Coase Theorem: in the absence of transaction costs, the involved parties can bargain to a mutually beneficial efficient outcome. Problem is, transaction costs are almost never zero, so bargaining to a mutually beneficial outcome could be costly, perhaps so costly that exchange wouldn’t occur at all. This concept is very important for the possibility of market-based environmental policy – reducing transaction costs is a crucial component of enabling people to use markets to manage and optimize pollution.

Creating markets for emissions trading is a powerful way to decrease transaction costs. An important part of reducing transaction costs is the definition and enforcement of property rights, so that a company with a right to emit 50 tons/year can trade away some or all of that right, and will be held accountable for the amount that it does emit. So if it can make more money by selling the right than using it, it can sell it and reduce its emissions. Notice how this trade creates value by putting the emission rights in the hands of people who value them the most (some of whom might retire them so that those emissions will not happen, ever).

Chicago Climate Exchange’s proactive market-based approach to emissions reduction is a watershed in emissions policy, for many reasons. First, it is proactive; the SO2 "cap-and-trade" emissions trading that came out of the Clean Air Act amendments of 1990 followed on decades of command-and-control regulation, which had the possibility of creating vested interests in the existing command-and-control regulatory institutions. Second, and more importantly, the Chicago Climate Exchange involves the stakeholders themselves determining the number of emission credits to have, and the rules. Trading purists (like myself, I admit) have criticized the SO2 emissions trading process on the grounds that determining the cap, the number of emissions credits, is prone to political manipulation and is therefore not a very secure and well-defined property right. The security and definition of the property right is a crucial component of putting the Coase Theorem to work here -- only if the property right is secure and well-defined do the market participants get as much benefit as possible from the exchange.

Chicago Climate Exchange is following a process by which the participants themselves, with all of their diverse interests, incentives and backgrounds, determine the cap. Technically speaking, this collaborative process endogenizes the property right definition process. They will also set rules for changing the cap, which will create security and certainty of the property right. That security reduces transaction costs, leading to increased trade and the creation of value.

Last week's Economist has an article profiling Chicago Climate Exchange.

posted by lkkinetic | 10/23/2002 06:27:00 PM

Monday, October 21, 2002  

COMPETITION AS A DISCOVERY PROCESS HOLDS FOR CELL PHONES, TOO: I love this Tech Central Station article by Steven Den Beste. He describes in great detail the evolution of competing standards for cellular phones in the US, versus the "harmonization" and settling on GSM as THE standard in the EU. Punch line: North American cellular networks and phones are more technically sound, and are updating to changes more easily. This is an important point: competition of standards enables a better standard, or set of standards, to evolve because they adapt better to the unknown. Here are some excerpts, but I recommend reading the whole thing:

If the U.S. had followed the same policy as Europe and mandated a standard, the CDMA air interface would never have been given the chance to prove itself. We in the U.S. now have just as good of nationwide systems and just as much roaming ability as the Europeans do, only our best systems are fundamentally better on a technical level than the best European systems, and are upgrading sooner with less pain. I can use my Verizon handset nearly anywhere in the U.S. or Canada that has cellular coverage at all (which is an area much larger than the EU), either directly on Verizon or roaming on a compatible system (such as Canada's Bell Mobility). ...

This kind of thing has played out much the same way hundreds of times before between Europe and the U.S., and nearly always it's had the same result. And as Europe increasingly centralizes and "harmonizes" and moves more and more authority to Brussels, it's going to keep happening. Decisions will be made from the center, and a lot of the time they'll be made wrongly because the "center" is not the infinite repository of all knowledge and wisdom. The "center" chose GSM (and thus TDMA) to be the winner; America decided to let the market pick the winner, and it didn't turn out to be TDMA. And now Europe is switching to the superior CDMA air interface which could never have been developed in Europe because of government regulation.

European centralization turned out to be a competitive advantage - for the U.S. And that's going to keep happening. If I was vicious and wanted to wish commercial failure and misery on Europe, I could think of nothing better to inflict on it than the process going on now whereby more and more authority will move to Brussels to be used by unelected bureaucrats who answer to no one, and will make binding technological decisions based on politics and ideology.

posted by lkkinetic | 10/21/2002 09:15:00 AM

According to the most recent annual survey of electric deregulation by Deloitte and Touche, consumers are at a six-year low in their awareness of energy issues. The study correctly draws the conclusion that this lack of awareness in electricity stems from the stagnation of restructuring in the post-California, post-Enron environment of political and financial uncertainty. Interestingly, over half of those survey supported Russia's selling crude oil in U.S. markets.

posted by lkkinetic | 10/21/2002 09:05:00 AM

BACK FROM DC: I am back from my electricity and experimental economics-fest in Washington, where I read this good Washington Post column by David Ignatius on the question of whether attacking Iraq is about oil. He points out some of the important economics of global oil markets, which politicians and pundits often conveniently forget. He also points out the possibility that oil prices could actually decline dramatically in the next year to 18 months.

UPDATE: Nat Treadway, an electricity industry expert upon whom I rely for clear and sophisticated analysis, pointed out to me in an email that he was not entirely impressed with Ignatius' article:

It seems that the Post's David Ignatius is unwilling to state whether HE thinks it's all about the oil. I understand and agree with his remarks about future
oil prices, but that perspective (costs to decline) would uphold the "it's all about the oil" thesis, would it not? He targets those who take this position, but I don't think it's
much of an article because he plays with a serious premise without taking a stance.

This is a good point, and one that had not occured to me, so I thank Nat for his contribution. Hmm, I wonder if the Socratic-type analyses through which I put my students has inured me to noticing such things ... ?

posted by lkkinetic | 10/21/2002 08:25:00 AM

Tuesday, October 15, 2002  

Tech Central Station is full of goodies today, including this article from Jennifer Zambone on experimental economics, Arnold Kling on investing and the margin of safety, and Jim Glassman on investing in the "Nifty 50". Very interesting. OK, I'm off to teach.

posted by lkkinetic | 10/15/2002 09:22:00 AM

3-D IMAGING OF UNDERGROUND OIL DRILLING: Okay, I admit it, I'm a gearhead. Tools, gadgets, all very cool. Energy industries are chock full of really cool technology, as indicated in this Globe and Mail article about 3-dimensional computer imaging of potential drilling sites, based on seismic data. Such technology enables the petroleum engineer to survey the plot from Calgary instead of having to schlep to the far, chilly corners of Canada. Very cool.

posted by lkkinetic | 10/15/2002 07:54:00 AM

Monday, October 14, 2002  

EMERGENT ORDER AND THE INTERNET: Here is a nifty Economist article on how the Internet is scale-free, and has evolved into an order that is less random than you might think. These traits have implications for many things, including how you address viruses. It's a great example of decentralized, emergent, spontaneous order, and it does have order as one of its characteristics.

posted by lkkinetic | 10/14/2002 02:32:00 PM

MORE ON EXPERIMENTAL ECONOMICS: David Warsh has written this superb column on experimental economic's development, and Vernon Smith's role in that development. He tells the story very well, illustrating the experimental diaspora from the vibrant group of scholars at Purdue in the late 1950s and early 1960s. Warsh also mentions one of those scholars, Jonathan Hughes, who was a pioneer in applying rigor and economic analysis to economic history. Hughes was the author of two very important books about entrepreneurship (The Vital Few) and the history of government involvement in the U.S. economy (The Governmental Habit), among his many other achievements. He was also a professor of mine in graduate school, a wonderful role model, and a genuinely good person, in addition to being a fantastic economist.

posted by lkkinetic | 10/14/2002 08:45:00 AM

Thursday, October 10, 2002  

Virginia Postrel's New York Times column today addresses new institutional economics and the rich array of fascinating economic research going on in NIE right now.

posted by lkkinetic | 10/10/2002 12:12:00 PM

REASON INTERVIEW WITH VERNON SMITH: This Reason interview with Vernon Smith is a good read, with lots of insight into experimental economics. And this New York Times article from today discusses both Smith's and Kahneman's work.

posted by lkkinetic | 10/10/2002 11:58:00 AM

WALL STREET JOURNAL EDITORIAL: I have an editorial in the Wall Street Journal today on the importance of experimental economics and Vernon Smith's Nobel prize.

posted by lkkinetic | 10/10/2002 11:56:00 AM

Wednesday, October 09, 2002  

VERNON SMITH WINS NOBEL PRIZE: Vernon Smith has won this year's Nobel Prize in Economics for his pioneering work in experimental economics. This is outstanding! See the press release from Mercatus for further details. See also my post from yesterday about electricity experiments and demonstrating the benefits of choice. Vernon Smith and his work form part of the foundation of why I named this website "The Knowledge Problem". Many, many congratulations.

Smith will share the Nobel this year with Daniel Kahneman, whose behavioral work integrates psychology and how humans make decisions in the face of uncertainty into economics. Kahneman's seminal work with Amos Tversky has really broadened our understanding of human decision-making.

This is a great Nobel year.

UPDATE: Article from Washington Post, and Nobel press release.

posted by lkkinetic | 10/09/2002 09:25:00 AM

Tuesday, October 08, 2002  

BRAVO FOR ANDREW CASSEL! In a Philadelphia Inquirer column yesterday, Andrew Cassel said it beautifully:

The real shame of Enron isn't that its top executives got filthy rich off of crooked deals and phony accounting. It's that the company took a good idea and poisoned it.

The good idea is competition, specifically competition in the production and delivery of electricity. It's an idea that has already brought significant benefits and will bring many more if it grows and evolves.

Read the column, and don't blame Enron on deregulation or markets or anything other than the greed and lack of integrity of a few venal characters.

posted by lkkinetic | 10/08/2002 12:57:00 PM

REASON'S INTERVIEW WITH STEVEN PINKER: I've been reading Steven Pinker lately, and his new book The Blank Slate has just arrived. In The Blank Slate Pinker takes on three "myths": the blank slate, the noble savage, and the ghost in the machine. I think the implications of his research, and his writing for laypeople, are profound for economics and the importance of human nature. The most recent Reason magazine has a really, really good interview with Pinker, in which he discusses his new book and other important issues. I recommend the interview, and Pinker's writings, highly. He'll make you stop and think.

posted by lkkinetic | 10/08/2002 12:52:00 PM

Experimental Economics and Retail Electricity Deregulation: Demonstrating the Benefits of Choice

Regulatory change in electricity moves slowly, in part because of human dislike of change and aversion to risk. Convincing people that regulatory change is worth undertaking would be a lot simpler if we could demonstrate the possible outcomes of a change, and thereby that such change need not be disastrous and could even create value and opportunity for many people. But electricity networks are so complex, and so expensive to construct, that real-world experiments are very costly and unlikely to occur. It’s not like opening a new restaurant and seeing if consumers perceive value in the offerings of food, wine, service, and environment. In this context, the methodology of experimental economics is incredibly useful and can help us place bounds on what may occur if we implement fuller retail electricity deregulation. Experimental economics simulates environments having different rules, with real economic agents facing real choices, and with the potential to earn real money payoffs. Because rules influence incentives and therefore shape outcomes, rules and the institutions that create and enforce them matter, including regulatory institutions. Experimental economics can inform us about the relationships between different rules and institutions and different outcomes.

An experimental approach to analyzing electricity deregulation enables the abstraction of some features of real-world activity to focus on specific features. The recent electricity experiments of Vernon Smith, Bart Wilson, and Steve Rassenti, of George Mason University and the Mercatus Center, illustrate the power of experimental methodology to create information about what is likely, and what we cannot predict, from different features of electricity deregulation. They have created a portable laboratory setup, complete with laptops, wireless networking, and well-designed software, to perform electricity market experiments in a variety of locations, with diverse participants. This description of experimental economics from the Interdisciplinary Center for Economic Science website provides a good overview of experimental economics and how it helps us understand how markets work. Smith’s entry on experimental economics in the Palgrave Dictionary of Economics is also a useful description.

Recently they have been running electricity experiments with groups ranging from college students to Congressional staffers to federal energy regulators. The people in the experiment are electricity generators, participating in a wholesale generation market. They are the supply side of the market, and they can own different types of generation capacity – baseload (low cost), intermediate cost “load followers”, and high-cost peaking units. These levels realistically reflect a typical supply curve, in which generators run their least expensive units until they hit capacity, then move to the intermediate-cost plants, and only run the expensive peaking plants during periods of peak load. Generators bid by submitting schedules of asking prices for their capacity in a given period, and all generators receive the market-clearing price. These rules mirror those found in many wholesale electricity markets. Generators can also have market power, depending on what kind of capacity they own and how concentrated that ownership is.

The experimental design can also vary the rules governing the expression of demand, either to reflect the current fixed “must serve” demand, or to test possible regulatory changes in how consumers are allowed to express their demand. Since state regulation of the electricity industry commenced in 1907, retail customers have faced average rates that change infrequently. Retail electric service is provided on a guaranteed-price basis, under the regulatory “obligation to serve” remit. In terms of consumer expression of their demand, these regulated rates have meant that consumer demand signals are metered, aggregated, and transmitted to suppliers on a monthly basis. With such unchanging rates, the demand or typical aggregate load profile fluctuates greatly across the day.

The response of the typical consumer may be “so what?” Because of the “obligation to serve” requirement facing utilities as part of traditional retail regulation, utilities must be able to generate or buy enough power to satisfy peaks throughout the day. Put another way, the responsibility for satisfying all consumers, whenever they want power, rests with the suppliers. Fixed, regulated rates mean that consumers have no incentive to take on any of that responsibility. The result of this supply-focused approach is lots and lots of generation capacity, because suppliers are required to serve all demand, whenever it occurs, without changing prices to reflect the different costs of serving that demand at different times. Retail prices cannot change even though costs do change, as captured in the three different types of plants used by the industry and in these electricity experiments.

In presenting the economics underlying the power of consumer demand in electricity markets, Smith analogizes between the electricity industry and other industries, particularly the airline and hotel industries. All three are service industries, facing peak demand that fluctuates and that determines capacity, with substantial capital investment requirements to satisfy demand. In competitive markets for airline travel and hotel rooms, where both consumers and producers can provide and respond to price signals, rates typically go up in peak demand periods and plummet in off-peak periods. The high rates in peak demand periods, rates that certainly exceed marginal cost, pay for the capital that is necessary to satisfy the peak, and the interaction of these price signals lead to optimal capacity investment.

That doesn’t mean, though, that all customers who want a seat or a room at peak will get it at a price they are willing to pay. So what do we all do when facing high airfares or hotel rates? We time-shift, traveling on a different day or at a different hour. Hotels and airlines do not operate under a regulatory obligation to serve, yet consumers deal with the fact that they might not be able to consume the flight or the hotel room they want when they want at the price they want. They deal by shifting their demand to different times, trading off convenience for cost depending on their individual preferences. Thus the comparison with the airline and hotel industries reveals exactly the extent to which the “electricity cannot be stored” rationale for regulation is a canard – airline travel and hotel service cannot be stored either, yet no one is arguing that these industries should operate under “must serve” obligations like those in the electricity industry.

In this article in Regulation in Fall 2001 (scroll to p. 70 for their article, although all three are well worth reading), Rassenti, Smith and Wilson compared two bidding systems in a wholesale electricity market – one with only supply-side bidding, and one with both supply-side and demand-side bidding. The demand side of the experiment proceeds as follows: take a very simple rule by which consumers can choose whether or not to let the retail electricity supplier interrupt their service at a couple of different points, and see what effect that rule could have on the outcomes in the wholesale market. They then divided the demand into four types: must-serve demand, off-peak demand, shoulder demand, and peak demand. Under fixed retail rates, all demand is essentially must-serve demand, including the high peaks. One of the important things to learn in this experiment is whether allowing consumers to choose to have their demand interrupted at two different prices would lead to increased consumer benefit, increased supplier profits, and any change in the ability of suppliers to exercise market power in the experiments when they have it. As Rassenti, Smith and Wilson say in their Regulation article, “our small simplifications enabled us to focus on the key issues we wanted to study while still capturing the essence of the daily natural cycle in demand in all electrical delivery systems.”

The generators then have to choose prices at which they bid into the wholesale market; in some experiments the generators face perfectly inelastic must-serve demand, and in some experiments they face consumers who can choose to have their service interrupted. In their experiments the timeframe is several days (compressed into a few hours), so the generators experience bidding over the fluctuating demand cycle. And, at the end of the day, the participants get to keep their profits (with some modifications when performed with government employees), so the incentives are real.

So what happened? When there was no demand-side responsiveness, suppliers with market power were more able and more likely to exercise it by withholding capacity. In the experiments with both demand-side and supply-side bidding, suppliers with market power were not as able to exercise it, and price fluctuations were smaller. Not only were average prices lower, but the variance of prices was also lower; demand responsiveness reduced price levels and price volatility, even in the face of supplier market power. When suppliers did not have market power, demand responsiveness still led to lower and less volatile electricity prices.

In their Regulation article, Rassenti, Smith and Wilson report these results from experiments performed at the University of Arizona. I have also seen similar results from experiments performed at the Federal Energy Regulatory Commission – yes, when facing profit incentives and no demand response, even the regulators exercised market power when they had it.

Experimental economics methodology improves upon “blackboard economics” in reflecting what Michael Polanyi calls tacit knowledge – when we make choices, including social interaction choices like market exchange, we are not always conscious of all of the information and knowledge that we bring to bear in making these choices. Experiments with real people facing real incentives create an environment in which the effects of tacit knowledge are not assumed away to solve the equations on the blackboard.

Market-based retail pricing is a crucial component of the ability to deliver choice and value to customers. Fixed, regulated average rates are an obsolete relic of a regulatory approach that, if it persists, will stifle the application of creativity in this industry. If utilities, regulators, and politicians consider the possibility that utilities can offer different value propositions to their customers than just “juice coming through the wall”, utilities can benefit from using market-based pricing as a tool for offering an attractive portfolio of service options to their customers. Creating value from this change, though, requires vision, and getting the transitions and the institutions right can be extremely tricky. Consumers will change how they think about buying electric service, and what that service is, exactly. For that change to occur, politicians and regulators will have to act on the leadership and vision that would allow consumers to take responsibility for their individual purchasing choices.

posted by lkkinetic | 10/08/2002 07:49:00 AM

Thursday, October 03, 2002  

THE ENERGY BILLS AND THE ADMINISTRATION'S PROPOSAL ARE STATIC AND BACKWARD-LOOKING: My colleague Adrian Moore and I argue in this policy analysis, published by the Institute for Research on the Economics of Taxation, that the administration's proposal and the House and Senate versions of the energy bill retain too much government manipulation of markets, and fail to recognize the range of institutional approaches available to address energy challenges.

posted by lkkinetic | 10/03/2002 11:37:00 AM

THE CONSEQUENCES OF FAILING TO DO SOUND ECONOMIC INSTITUTIONAL ANALYSIS: As I argue in this presentation delivered last week at the Ronald Coase Institute Workshop on Institutional Analysis, the bifurcated PX/ISO pool trading structure created a myriad of incentives for both buyers and sellers to behave strategically. Furthermore, because I was making a methodological point to the students, better institutional analysis could have lessened or prevented the ensuing losses and disruptions. I say could have because the political process could have meant that decision-makers would not have found it in their interests to listen to a sound institutional analysis, even if presented with it before the fact. Bottom line: institutions matter, and analyzing them and the incentives they create is important for good policy and good market design.

posted by lkkinetic | 10/03/2002 11:33:00 AM

Wednesday, October 02, 2002  

GOVERNMENT ROLES IN DISTRIBUTED ENERGY: Energy expert and industry veteran Ed Reid and I wrote this article for the Reason publication Privatization Watch. Punch line: distributed generation could go a long way toward helping us deal with energy infrastructure issues (especially transmission construction) in a cost-effective and flexible manner, but intended and unintended government barriers still exist. Here's the conclusion:

Government barriers to distributed energy do still exist at both federal and state levels, across many different agencies and regulators. The current unsettled state of the industry is an opportunity for a revised, coordinated regulatory approach that does not create disincentives for distributed energy. FERC’s interconnection initiative is a good start at the federal level to create coordination among the states, but many other barriers remain in other federal agencies and in other dimensions at the state level.

posted by lkkinetic | 10/02/2002 08:35:00 AM

My friends at the Center for the Advancement of Energy Markets have a superb rebuttal to a Houston Chronicle letter calling for the re-regulation of electricity in Texas. The author of CAEM's rebuttal, Nat Treadway, has written a clear and thoughtful reponse to this ridiculous idea.

posted by lkkinetic | 10/02/2002 08:23:00 AM

Tuesday, October 01, 2002  

MOTHBALLING OLD POWER PLANTS IN TEXAS: Here's a great example of the competitive, market process dynamic at work. According to this article, American Electric Power is planning to retire, or mothball, 16 of its older gas-fired plants in Texas. The article says it well:

The decision to deactivate the plants is a result of the introduction of electricity deregulation and competition in Texas. Many new, highly efficient power plants have been built in Texas as a response to deregulation. These new plants have lowered wholesale power prices to a point below the costs of generating electricity from the 16 older AEP plants.

This is beautiful -- competition has brought technological change to bear in electricity in Texas, so these older plants are now obsolete. Maybe Governor Davis should look at the Texas model if he wants to encourage supply (yeah, right, like that's gonna happen).

posted by lkkinetic | 10/01/2002 02:44:00 PM

WHAT'S NEW WITH THE CALIFORNIA WHOLESALE PRICE CAP? I haven't focused on it much here, but the FERC had set the wholesale "soft price cap" in California to rise from $91.87 to $250 today. As this article reports, the new price cap has been delayed a month to allow officials to incorporate changes from a computer test of manipulation possibilities. Of course, this is all happening in a very politically charged environment -- FERC is in the process of taking comments on its proposed standard market design, El Paso is accused of exercising market power on its natural gas pipeline at the California border, and Governor Gray Davis simultaneously wants to reverse the increase in the price cap and to force the companies who had proposed building new capacity to go ahead with those proposals, even though the wholesale price of electricity is now hovering around $30/MWH (which is quite low).

But wait, the intelligent reader says, how can Davis simultaneously argue for maintenance of a low price cap and forcing companies to invest in California to increase supply? Precisely. When it looked like electricity prices would be sustainably high, investors were certainly more willing to propose new generation for California than they are at $30/MWH. Now, though, even the $91.87 price cap has not been binding except for a very few instances, and, guess what? Investors don't see much potential for returns from putting new generation capacity in for California. Add to that the regulatory uncertainty of the future of the wholesale market in California, and is it any surprise that investors are wearing a clear path to the border, or staying away?

Thankfully, FERC Chairman Pat Wood gets it. According to the article cited above,

While the state's governor, Gray Davis, has criticized the lifting of the California cap to a higher level as giving an opening to generators to profit unreasonably, in his view, Wood pointed out that California's cap is below similar caps in other parts of the country, and would represent a step to encourage new supply in the state.

Here's a simple economics lesson for Governor Davis, along the lines of Megan McArdle's wonderful explanations of the power of simple economic ideas. Think about a typical representation of a market outcome, with a typical supply curve and a typical demand curve. The story we usually tell about equilibrium price is that the interaction of buyers and sellers communicates information about costs and preferences, and that in an equilibrium, all who are willing to pay above that price get the good, and are supplied by those whose costs are lower than that price.

But what else do we know is true at that equilibrium? Most of the consumers pay less than they were willing to, because all pay "the market price". And, most of the suppliers earn more than their marginal cost that they had to recoup to bring the good to market. These two amounts are called consumer surplus and producer surplus. For those of you who, like me, like to shop, getting a bargain is the best way to understand consumer surplus -- if you looked at a sweater and you thought you would pay up to $50 for it, but you only had to pay $29.99 because it was on sale, then you just got $20.01 in pure consumer surplus. Score! Same story, but a little less intuitive, if you are a producer -- you only have to receive your marginal cost to be willing to sell something, but at an equilibrium like I've described, you get paid more than that for what we call the inframarginal units (the ones sold up to but not including the last one). Score!

OK, now the tricky question, especially for Governor Davis. Is producer surplus price gouging? In the simple scenario I've constructed, absolutely not. That producer surplus is going to repay the producers for the fixed costs they've had to incur to bring their stuff to market -- buying computers, building factories, building generation capacity, whatever. And you know what? If not enough stuff is being produced to satisfy consumer demand, scarcity becomes more binding and equilibrium prices rise.

This scenario also applies to electricity, but it's a little more complicated because of the very high fixed costs in the industry. Building generation capacity is not cheap and not quick. So that producer surplus sends a very important signal, a very important set of information, to producers and potential producers about what kind of investment needs there are to satisfy demand in this industry. That's one reason why another term you'll hear applied to this idea is scarcity rents, and that as scarcity becomes more binding, existing producers earn more money from it and potential producers see profit opportunities in alleviating it, which they would do by investing and entering the market.

This idea of producer surplus raises another really, really important point that frequently gets overlooked in the policy debates and media discussion: the simple scenario I described above is about static efficiency, a snapshot-in-time one-shot idea. But what determines growth, productivity, and incentives for things like technological change is dynamic efficiency, which requires us to look across time.

Punch line: producer surplus promotes dynamic efficiency by enabling producers to earn the means to pay for their investments. If there's scarcity relative to demand, producer surplus will include some scarcity rents, which signal to opportunistic investors that they should look here to profit from alleviating that scarcity in the future.

And price caps cut those incentives out at the knees. So Governor Davis cannot have it both ways, at least not without compulsion and coercion. And last time I checked, you cannot force actors in a free and open society to invest within the bounds of your geopolitical universe.

posted by lkkinetic | 10/01/2002 02:37:00 PM

THANKS TO ARNOLD KLING: While I was away, Arnold picked up on a couple of my posts in the context of a commentary on Krugman's column last week about the California energy crisis. I think Arnold is absolutely right to say that "most economists would predict that California's experience is not the shape of things to come. Even among those who believe that companies found it profitable to withhold energy (and by no means do all analysts hold this view), there is a consensus that the California regulatory regime had unique aspects which made it brittle when demand increased." Arnold's post has his usual good discussion question, which I will pose to my environmental economics class later this quarter. Thanks!

posted by lkkinetic | 10/01/2002 01:55:00 PM

ISNIE: After the Coase workshop, most of the attendees stuck around for the annual conference of the International Society for New Institutional Economics, which had lots of great papers on electricity, so I was thrilled.

posted by lkkinetic | 10/01/2002 01:53:00 PM

WHERE HAVE I BEEN? In a hotel that only has dialup, that's where! Last week I was honored and delighted to be on the faculty of the Ronald Coase Institute's Workshop on Institutional Analysis. The workshop gathers together 25-30 economists from developing countries, either graduate students or young Ph.D.s, who are doing research on formal and/or informal economic institutions in their countries. The idea is to incorporate their local knowledge with good economic analysis and an understanding of the importance of institutions, contractual forms, the transaction costs that can impede certain transactions or contractual forms, and so on. I had a great time, and learned a lot.

posted by lkkinetic | 10/01/2002 01:51:00 PM
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