Tuesday, August 23, 2005

Could Paul Ehrlich Win His Bet?

These are strange days. The New York Times’ editorial writers now side with Julian Simon (see John Tierney’s 8/23/2005 op-ed titled “The $10,000 Question”). Could economic optimists be wrong about oil price dynamics over the next 20 years? The “new” conventional wisdom argues that suppliers and demanders, anticipating rising prices, will adapt in advance and pre-empt a price spike. Let me play Devil’s Advocate.

Concern #1 Job Sprawl

A growing share of households lives and works in the suburbs. If the price of gasoline did triple, could these folks substitute to the bus or rail transit? I don’t think so. Given that vehicles are durables that a household expects to own for about ten years, consider a suburban household who owns two vehicles that are both 5 years old and that get 25 MPG. If the price of gasoline tripled, these vehicles would have a very low re-sale price as many suburban households scrambled to downsize and buy a new more fuel efficient vehicle. Middle class suburban households would bear the price impacts.

Concern #2 Green R&D by Vehicle Manufacturers

How much money are car makers such as Toyota really investing in green technologies? My intuition tells me that they invest more if they expect that the real price of oil will rise over time. How do such car makers form their expectations of future gas prices? Are they simply extrapolating based on past gas price trends? Are they hiring fancy economic consulting companies to form forecasts for them? How do these economic consulting firms forecast? Using structural models of supply and demand? Or do these consulting firms charge a lot for simple time series extrapolations?

Economists have written a lot about the induced innovation hypothesis. One nice study documented that air conditioners become more energy efficient when the price of electricity is higher. Another study documented that patents geared toward inventions that conserve on energy consumption increase when energy prices are higher. These examples highlight the importance of expectations of future oil prices. But where do these expectations come from? Rational expectations economists and behavioral economists would give different answers to this question. I’d like to know what the important decision makers at the major vehicle makers are thinking. If they guess wrong and bet that gas prices will stay low, is it easy to enter this industry? If there are MIT engineers designing green cars, can they get big loans from the capital market to scale up their dreams in the state of the world where gas prices rise?

In China in the year 2015, what will be their fleet’s average fuel economy? Are planners there taking pro-active steps to economize on gasoline consumption?

Concern #3 Green Car Production Capacity

If the price of gasoline tripled, do vehicle makers have the capacity to scale up their production of hybrid vehicles? How easy is it for these producers to substitute from producing conventional vehicles to these “special” vehicles?

Has the conventional wisdom now shifted from “doom and gloom” Club of Rome to Lomborg optimism? Can this have a lulling effect such that Ehrlich wins his bet?