California Energy Tax Proposal

The problem with subsidies, in general, is that the market doesn’t pick the winners – politicians do.

A ton of money is being sunk into ethanol right now which can never replace gasoline for a myriad of reasons. Essentially, we are spending money on a band-aid that is drawing money away from a solution that could be the Real Thing.

First, I think the problem of an optimal subsidy is a very difficult one. In case of scientific research it is not the case that you always get diminishing returns. Indeed, it could be the opposite. All dollars spent that don’t lead to a breakthrough have a return of exactly nothing. The additional dollar that leads to such a breakthrough has an enormous return. Further, by definition, since we are talking about research, we don’t know ex ante what value a successful breakthrough will have. So, how does one know what is the proper level of subsidy when one does not know the value of product that results?

Second, we don’t know what the costs of not having a breakthrough are. What is the probability that oil revenues to Islamic fanatics will lead to a terrorist attack? How much CO2 emissions is too much? What is the probability that weather patterns like Hurricane Katrina are worsened by global warming? How much damage does that marginal worsening cause? What diseases are caused by particulate pollution from gasoline compared to a clean-burning fuel, and how do we appropriately value the prevention of those diseases? Essentially, the problem here is that we do not know what the cost of not acting are.

From this, we can conclude the following. Kling’s personal opinion that we are “probably” spending too much on subsidies is not worth all that much. Just as my personal opinion that we are “probably” spending too little is not worth all that much. Neither of us knows what the value of breakthroughs from research and development are and neither of us knows exactly what the costs of the status quo are.

There is, however, a tie-breaker that I think suggests that we should spend more on alternative energy. Through subsidizing energy research at universities, we could 1.) attract new students into the fields of engineering and science, 2.) specifically target mathematically gifted economics majors with subsidies to switch to engineering or science with a focus on energy research. Why would we want to waste a mathematically gifted individual on a subject with as little value as economics? Especially when said economics majors (with Ph.Ds no less) keep mentioning the signaling model suggesting that education does not have much substantive value. Could it be that it is not education generally that does not have much value, but rather just economics? I think with engineering and science, it is an entirely different story. In those fields you acquire actual knowledge and skills; your education is not merely a matter of sending a signal to superficial investment banking firms, but rather, you actually learn substantive things. Individuals with strong mathematic backgrounds are a scarce resource, and we should attempt to avoid having them wasted on economics since the positive externalities from the actual substantive knowledge of engineering majors far exceeds the personal signaling effects that economics majors receive.

It is kind of like research into NASA. The positive externalities of such research have been very high. There is no reason to think that the positive externalities of energy research will not likewise be high.

Another tie-breaker in favor of more research is that while we don’t can’t precisely measure the externalities, we do know that they are very serious.

I want to address another point. So-called rent-seeking. Yes, corruption does exist in the public sphere. But it exists in the private sphere as well. Corporations face major agency costs, as was illustrated by the Enron scandal and is illustrated by the power that executives have over their own perks and compensation. What would be the response of someone in the private sphere to a scandal in the private sphere: This is just an isolated incident! It says nothing about the vast majority of businessmen, who are honest and trustworthy. The same scandal in the public sphere: This is an illustration of why the public sphere cannot be trusted! They are corrupt to the core.

Rent-seeking or agency costs exists in all spheres of life. They key is to try to minimize them in whatever sphere they exist, not live under the illusion that they are exclusive to one sphere or another. The private sphere consists of people. The public sphere consists of people. Similar problems exists in both spheres. Is this suprising??

Chris makes the point that the market does not pick the winners with publicly funded research. But doesn’t that depend on how the research program is structured? And in truth, even in the private sphere, the market does not simply pick the winner. Private companies consist of fallible individuals in positions to impose their preferences. Corporations are limited in their ability to make bad decisions only to the extent that such bad decisions may lead them to go out of business. But it is exceedly rare for a large corporation to mistakes with large enough effects to lead to that kind of result. The takeover market is both underinclusive and overinclusive with respect to the companies that face discipline. Which is not to say that the private market does not function, only it is very far from functioning perfectly. Sounds like the public sphere.

Finally, having the “market” decide on the winners is part of the problem to begin with. Since the market does not consider externalities, markets make bad choices.

Via Mankiw, here is an econ 101 examination of Prop 87 and why it won’t lead to an increase in gas prices.

And, – before I forget it:

He recently said that the downside of oil falling below $70/barrel is that it makes alternatives uneconomical.

Me wonders sometimes, how naive some followers of the political right in the US are. Bush is certainly not worried about oil prices being to low, because of it’s negative effects on research incentives in regenerative energies. He is just worried about the profit margins of his buddies in Big Oil. Anyone who believes in what Bush says publicly regarding the environment is either stupid or plainly uninformed.

If oil prices does decrease then the incentive to find alternative fuel source does go down. Although I think the fact that we rely on the foreign nations for oil like the Middle East is a strong incentive for finding alternative fuel source. It wouldn’t surprise me if some of our money we pay to OPEC goes to the terrorists. We do have a source of energy that is safe, efficient, and environmental-friendly called Nuclear Energy but people don’t want to use it though for cars would need something else.