Some important topics:The oil premium and the rebound

effect

Economics 331bSpring 2010

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The Oil Premium

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Sources of the Oil PremiumPollution (by air and other regulations)Congestion (generally ignored, but could use

congestion pricing)Monopsony premium (pecuniary, affects oil

expenditures)*Macroeconomic externality (inflation and

unemployment in Keynesian world)*Global warming externality from CO2 (later in course)*Road safety (regulation, insurance, liability laws)Economic losses from disruptions (tough to estimate)Military costs (tough to estimate)

* Covered today or later in the course.

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Basic calculation of the premium

The “oil premium” refers to the excess of the social marginal cost of oil consumption over the private marginal cost.

Analytically, this is

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"Oil supply monopsony various

premium" price premium externalities

supply oil -

price taxes

monopson

y various oil

- premium externalities taxes

The monopsony premium

55Q(free market)

P, MC of oil

Imported oil

S

MSC

Import premium at free-market imports“Optimal

Tariff” atOptimized oil imports

Q(“optimal”)

D

Optimal tariff (monopsony) reasoning on oil taxes

Basic argument. 1. The point is consumers have market power in the world oil market. By

levying tariffs, consumers can change the terms of trade (oil prices) in their favor.

2. Regulation and taxes are a substitute for the optimum tariff.Simple reasoning:• world supply curve to US: Q = Bpλ , λ>0; so p=kQ1/λ • US cost of imported oil = V(Q) = pQ = kQ(1+1/ λ) (k an irrelevant constant)• marginal cost of imported oil = V’(Q) = (1+1/λ) kQ1/ λ = p (1+1/ λ) So optimal ad valorem tariff is :

τ = 1/ λ = inverse elasticity of supply of imports

Reference: D. R. Bohi and W. D. Montgomery, “Social Cost of Imported Oil and UU Import Policy,” Annual Review of Energy, 1982, 7, 37-60.

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Optimal tariff argument (continued)

Complications: This is oversimplified in bathtub model. Formula actually is

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, ,

If we put in "standard" elasticities, we get:

1 79 ( .5) 658.0

79 65Which implies an ad valorem optimal US tariff of about 12%.

S ROW ROW D ROW ROW

ROW ROW

S DS D

Optimal tariff argument (continued)

Some notes:

1. Supply elasticity depends critically on whether oil market is at full capacity (2007 v. 2009). Very inelastic in full capacity short run; quite elastic when OPEC adjusts supply.

2. The optimal tariff in $ terms depends upon the initial price because it is an ad valorem tariff.

3. The externality is a global externality for consuming countries because it is a globalized market (in bathtub world).

4. Note this is a pecuniary, not a technological externality. So it is a zero-sum (or slightly negative-sum) game for the world. This has serious strategic implications and suggest that the diplomacy of the oil-price externality is completely different from true global public goods like global warming.

5. This does not have to be a tariff. It is really a “shadow price” on oil imports.

6. This is an example of “Ramsey tax theory” with inverse elasticity formula.

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Price

Production

Short-run production capacity

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The monopsony premium differs greatly depending upon the state of the world oil market.

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

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1/

(1) Domestic or consumer prices = = import price + tariff = p +

(2) Oil supply to the US: Q Bp B( - ) , or p = (Q/ B)(3) Assume that marginal value of oil in US is constant at (in

v

vv

[1 1/ ]

finitely elastic demand) So we want to

(4) max

Maximizing with respect to Q leads to a maximum value of tariff:(5) [1 1/ ] Since consumer prices are equal to marginal v

QvQ pQ vQ bQ

v p p

alue of ,

we set the optimal tariff as(6) = ( )/ 1/ = inverse elasticity of import supply.

v

p v v

Numerical example for US

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Variable

Elasticity of supply of oil 0.1 1 5

Domestic production (10̂ 6 bbls/ day) 6

Imports (10̂ 6 bbls/ day) 14

Domestic demand (10̂ 6 bbls/ day) 20

Global production (10̂ 6 bbls/ day) 85

Oil price (2009 $/ bbl) 50

Elasticity of demand for oil -0.5

Elasticity of imports w.r.t. oil price 2.9 8.0 30.5

Optimal tariff on oil ($/ bbl) 17.33$ 6.28$ 1.64$

Optimal tariff on oil (c/ gallon) 41 15 4

Macroeconomic externality

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Somewhat more tenuous is the macroeconomic externality.Idea is that there are impacts of changes in oil prices on macro economy because of inflexible wages and prices.So have another linkage:

The second term was discussed in optimal tariff. The first term comes from macroeconomics (see next slide).This, however, is very controversial and the estimates are not robust.

( )( ) ( )( ) ( ) ( )

oil priced realGDP realGDPd oil consumption oil price oil consumption

Macroeconomic externality (cont)

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Simplified derivation:

We can also derive that monopsony/macro

= ε[GDP/pQ] = .017*(15000/450) = .56

macro

premium

Assume that = 2 and = -

( )( ) ( )( ) ( ) ( )

[ln( )][ln( )]

150007

oil priceQ

oil priced realGDP realGDPd oil consumption oil price oil consumption

realGDP realGDPoil priceoil price

.014

macro $18 / bbl

premium.017 15000

7 2

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A standard macro/oil-price equation with “good” results. Dependent Variable: LOG(GDPQ_BEA) Method: Least Squares Sample: 1971Q1 2009Q1 Included observations: 153

Variable Coefficient Std. Error t-Statistic Prob. C 4.399688 0.027266 161.3626 0.0000

LOG(RPOIL08) -0.017205 0.003546 -4.851700 0.0000 TIME 0.007508 3.89E-05 193.0151 0.0000

R-squared 0.996011 Mean dependent var 8.841860

Adjusted R-squared 0.995957 S.D. dependent var 0.333864 S.E. of regression 0.021228 Akaike info criterion -4.847622 Sum squared resid 0.067591 Schwarz criterion -4.788202 Log likelihood 373.8431 Hannan-Quinn criter. -4.823485 F-statistic 18724.88 Durbin-Watson stat 0.166943 Prob(F-statistic) 0.000000

Macroeconomic externality (cont)

Updated estimates

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

Policies on Oil (Energy) Use

Background– In general, first-best policy for reducing oil (energy) use

is taxes on oil (energy).– However, because of “tax-aversion,” governments often

substitute regulations. In this area, they are requirements on minimum energy efficiency

– A standard question is their efficiency relative to fuel taxes.

One specific case is: Do the induced effects of efficiency measures offset the direct effects and thereby lead to higher rather than lower energy consumption? The Rebound Effect

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Rebound effect

Who are the players?

Stanley Jevons: Introduced the idea that productivity improvements would lead to increased quantity because of price-elastic demand.

Daniel Khazzoom: suggested that gains in energy efficiency would lead to less than proportional gains in energy use.

Len Brookes: Energy regulation is completely ineffective because of rebound effect.

Michael Grubb: Economists do not understand the profound inefficiency of energy markets.

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Jevons paradox

“The economy of labour effected by the introduction of new machinery throws labourers out of employment for the moment. But such is the increased demand for the cheapened products, that eventually the sphere of employment is greatly widened.”

“The number of tons of coal used in any branch of industry is the product of the number of separate works, and the average number of tons consumed in each. Now, if the quantity of coal used in a blast-furnace be diminished in comparison with the yield, the profits of the trade will increase, new capital will be attracted, the price of pig-iron will fall, but the demand for it increase; and eventually the greater number of furnaces will more than make up for the diminished consumption of each.”

Jevons, The Coal Question

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The ineffectiveness of regulations

“As we have seen, the enormous improvements in energy efficiency that have taken place have been accompanied by increases in energy consumption not decreases…”

Len Brookes, Energy Policy, 1990

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The anti-rebound viewpoint“As many economists seem to have difficulty in understanding [why the

rebound effect is minimal], it is worth reciting at least seven reasons for it:

1. Lack of knowledge, know-how and technical skills.2. Separation of expenditure and benefit.3. Limited capital, often arising from external restrictions on capital

budgets.4. Rapid payback requirements.5. Structure of tariffs.6. Lack of interest in peripheral operating costs.7. Legal and administrative obstacles.

[Therefore], policies aimed at removing or circumventing these market obstacles, and installing efficient, cost-effective technologies, will save energy and bring both environmental and economic benefits.”

Grubb, “Energy efficiency and economic fallacies,” Energy Policy, 1990.

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Rebound effects: categories1. Direct rebound effect: Increased fuel efficiency lowers the cost

of consumption, and hence increases the consumption of that good because of the substitution effect.

2. Indirect rebound effect: Through the income effect, decreased cost of the good enables increased household consumption of other goods and services, increasing the consumption of the resource embodied in those goods and services.

3. Economy wide effects: New technology creates new production possibilities in and increases economic growth.

For small industries, #1 will dominate. #2 will almost always be too small to offset small #1.#3 is unclear about the mechanism that the authors are talking

about.

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Direct rebound effect…

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G

Price of vmt

Before mpg improvement

Gasoline consumption

Effect of efficiency improvement

“Rebound effect”

After mpg improvement

… or maybe …

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G

Price of vmt

Before mpg improvement

Gasoline consumption

Effect of efficiency improvement

“Rebound effect”

After mpg improvement

But welfare improvement is unambiguous

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G

Price of vmt

Vmt

Welfare improvement

Economics of direct rebound effectAssume that regulation increases energy efficiency of a capital

good from mpg0 to mpg1 . The question is whether the

lower cost of a vmt (vehicle-mile traveled) would offset the lower cost.

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vmt gasoline

(1) vmt = f (p ,p ), vehicle miles traveled,

(2) cars = f (p ,p ), number vehicles

From this we can get the following:

(3) Gasoline use = G = vmt/ mpg

(4) p = p / mpg

(5) ln / ln

vmtvmt cars

carsvmt cars

d G d mp

gasoline

gasoline

-1 ln / ln ln / ln

But we know from (4) that ln / ln ln / lnp , so

(6) ln / ln -1 ln / ln ln / lnp

which gives us the important result:

(7) ln

vmt vmt

vmt vmt

vmt vmt

g d vmt d p d p d mpg

d p d mpg d p d

d G d mpg d vmt d p d p d

d

gasoline/ ln 1 ln / lnp

So rebound effect is equal to the elasticity of vmt with respect to gasoline prices,

which we have observed in countless studies.

G d mpg d vmt d

Example of lighting: Did increased efficiency increase lighting

use?

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10.000

1.000

0.100

0.010

0.001500,00050,0005,000500505

Output of lighting

Pri

ce p

er lu

men

-hou

r

Example of lighting

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Dependent Variable: LOG(Output of lighting) Method: Least Squares Included observations: 7 after adjustments

Variable Coefficient Std. Error t-Statistic Prob. C 3.23 1.32 2.437 0.071

LOG(Price of lighting) -0.62 0.35 -1.762 0.152 LOG(GDP) 1.31 0.62 2.111 0.102

R-squared 0.985 Mean dependent var 6.764

Adjusted R-squared 0.978 S.D. dependent var 4.847 S.E. of regression 0.714

Suggests that Jevons effect does not hold. Inelastic demand.

Empirical estimates of rebound effect for autos

Basic results from many demand studies:*

Short-run gasoline price-elasticity on vmt = -0.10 (+0.06)

Long-run gasoline price-elasticity on vmt = -0.29 (+0.29)

Therefore, the rebound would be 10 to 29 percent of mpg improvement.

This can be applied to other areas as well.

Reference: Phil Goodwin, Joyce Dargay And Mark Hanly, “Elasticities of Road Traffic and Fuel Consumption with Respect to Price and Income: A Review,” Transport Reviews, Vol. 24, No. 3, 275–292, May 2004, available at http://www2.cege.ucl.ac.uk/cts/tsu/papers/transprev243.pdf

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30Source: UK Energy Research Centre, The Rebound Effect

What about behavioral effects?

This is largely an open question.

1. There are apparently major inefficiencies in energy use:- People overdiscount future energy gains- People don’t know the MPG of their cars- Example: people will pay $1 to avoid $2 in present

value of future gasoline use.- Why???

2. After almost 4 decades, we still don’t know- Why people have these inefficient patterns. - What to do to change them and to make people

“energy smart.”

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