What’s wrong with transportation
markets and how do we fix them?
Christopher R. Knittel
Department of Economics and
Institute of Transportation Studies, UC Davis
and NBER
Roadmap
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The outcome of a well functioning market
“Thinking like an economist”
The different market failures in transportation/energy
markets
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How to fix them
Arguments against these fixes
Alternatives
Economics culture: please interrupt with questions or
comments
The “first best”
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To say a market is not working requires defining
the optimum
• Economists have a very specific notion of efficiency
• Pareto efficiency: It is efficient, if it is not possible to
reallocate resources and make one agent better off
without harming another agent
• Notice: nothing about equality
• The idea is to maximize the size of the pie
• If we don’t like the distribution of the slices, we address
that through policies that don’t affect the size of the pie
•
These are transfers that don’t affect the actions of agents (more
on this)
Market failures
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If the market does not lead to a Pareto efficient
outcome, we say it “fails”
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Transportation markets have many failures
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It is the existence of market failures that opens the door for
policymakers (and, thus governments)
My plan is to discuss the main ones
Notice that this is powerful: If you can’t point to a
market failure, then the market will maximize the size of
the pie
•
Government intervention can only reduce the size (weakly)
Some principles of economics
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People/society face tradeoffs
People respond to incentives
• These seem obvious
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People/firms think at the margin (and policymakers
should too)
• For example, consumers compare the cost of driving one
more mile with benefit of driving one more mile
• Or, firms compare the cost of selling one more gallon of
gasoline with the benefit
• Therefore, to influence behavior, you have change
incentives “at the margin”
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Trade can make everyone better off
• Trade allows those firms more efficient at doing
something (e.g., abatement) to do more of it
• Trade maximizes the size of the pie, but doesn’t guarantee
everyone gets a larger slice
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The cost of something is what you give up to get it
• “Opportunity costs” matter, not accounting costs
Some observations
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The first best depends on the current system
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The optimal transportation system if we were starting “from a
clean slate” can be dramatically different compared to if we
are not
• This is the “at the margin” point. Sunk costs---those costs that
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have been incurred and cannot be recovered---do not and
should not matter
So, fuels like hydrogen are (and should be) at a disadvantage,
relative to starting from the beginning
• The infrastructure for these fuels hasn’t been built, so these high
capital costs are not sunk and should be considered
• The optimal system can vary by country
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If a consumer faces the true social cost of something and
chooses to purchase it, then this is good for society
•
If you don’t agree with their decision, then either (a) you think
you know more about their utility function than they do, or
(b) you think their preferences are wrong
• Most economists are hesitant to say (b)
•
Personally, I find it fairly elitist
• (a) is possible if there is some lack of information, but we need
to point to the information asymmetry
• What does this mean? If the price of driving a Hummer
included all of the social damages and someone wants to
still drive it. Great!
Analyzing market failures
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The ultimate goal is to understand how market
failures affect efficiency and to design policies
that correct these failures
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Market failures come down to consumers/firms
not facing the correct marginal incentives
• Either prices or benefits are too high/low
Major market failures present
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Externalities
• Failure of agents to face “correct” costs/benefits
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Network Effects/Coordination problems and
investment spillovers
• Failure of agents to face correct benefits
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Market power
• Firms pricing above their marginal cost (incorrect
MB)
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Asymmetric Information
• Can lead to “missing” markets
The pillars of economics
S = marginal social
cost
P
First, the ideal
P*
D = marginal social
benefit
Q*
Q
Negative externalities
marginal social
cost
P
DWL
S = marginal
private cost
P*
PNE
D = marginal social
benefit
Q*
QNE
Q
Negative externalities in transportation
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Pollution
Climate change (or risk of)
National defense
Congestion (time varying)
Accident risk (not discussed much)
In each case consumers/firms do not face the
true cost of their decisions
Most frustrating part of being an
economist
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Solving the negative externality problem is
simple
• Place a tax on the item equal to the negative
externality
• So-called Pigouvian Tax
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Advantages:
• Direct,
• Generates revenues,
• Doesn’t require knowing Q*
Negative externalities
S=
P
t
Private cost +
tax
marginal
private cost
P*
PNE
D = marginal social
benefit
Q*
QNE
Q
Arguments against taxes
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Political infeasible
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I agree, but it remains our duty to continue to remind
policymakers that it is the most direct and easiest way to solve the
problem
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They might be politically infeasible because we stopped doing this!
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We should continue to calculate the social cost of this infeasibility
Major problem: we’re battling against oil and auto companies
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Research suggests gas taxes are progressive up to the first 3 deciles,
regressive from 4-10
• Shameless cite warning: See, Fowlie, Knittel and Wolfram (2006)
Harms the poor disproportionately
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Remember, a tax generates revenue that can be distributed!!!
Proposition 87 was almost perfect
Arguments against taxes (cont)
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Transportation demand is too inelastic for taxes to
“work”
• Shameless cite warning: See, Hughes Knittel and Sperling (En. Jo. fthcmg)
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Notice, this just suggests that Q* and QNE are close to each
other
• Suggests we should look elsewhere for carbon decreases, whether we like
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it or not
Price inelasticity and carbon inelasticity are not equal
• Suppose there was an alternative fuel that had 25% less carbon, but
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always costs 10 cents more than gasoline
With no carbon tax, this fuel would never be sold
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Even with a vertical demand: with a carbon tax of $0.41 per gallon, we would
all switch to it, drive the same number of miles and carbon would fall by 25%
Arguments against taxes (cont)
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Inelastic comment continued
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Long Run elasticities difficult to measure
• Not a perfect experiment, but there are major differences
between US and Europe
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VMT: The average car is driven 22% fewer miles/year
Ownership: Europeans own 30% fewer cars/person
Fuel efficiency: European cars get 41% better MPG
Total: Europeans consume 61% fewer gallons of gas
Arguments against taxes (cont)
$8.00
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$0.00
Belgium
France
Germany
Italy
Netherlands
U.K.
U.S.
Arguments against taxes (cont)
S=
P
P*
t
Private cost +
tax
marginal
private cost
PNE
D
QNE
Q*
Q
Arguments against taxes (cont)
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Requires knowing the damages
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Yes. And these can be difficult to measure
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But, any other policy instrument that I am aware of also
requires this
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• What is the value of a polar bear?
• And usually more
Lot’s of work on this:
• Most comprehensive, Parry and Small (Am. Ec. Rev. 2006)
• Risk, one paper Edlin and Mandic (J. of Pol. Economy 2006)
• Congestion, lots of work
• Infant Health (another warning: Knittel, Miller and Sanders [2008])
A nice alternative
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An alternative to a tax is a cap and trade system
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For example, gasoline refiners can face an aggregate carbon
cap and be required to have a permit for every unit of carbon
they “create”
• They would then trade among each other
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Very common in pollution market
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The basis for Europe’s Kyoto compliance strategy,
Northeastern NOx market for powerplants, CA’s RECLAIM
market for NOx, Australia carbon market, etc.
Cap and trade
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Why so common?
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Not a tax
Permits are typically allocated in political way
• This lessons the effect on firms and some firms can even profit
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This gets the firms “on board”
• Good thing: marginal incentives are independent of the initial
allocation
• First best is possible
• Can tighten the cap until the permit price equals the negative
externality
Cap and trade and S and D
P
marginal
private cost
PCAP
PNE
Permit Price
D = marginal social
benefit
QCAP QNE
Q
Arguments against cap and trade
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Positive demand shocks can lead extreme prices
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• In fact, you could cap it at the level of the externality!
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We’re back to the tax solution
Effectively, this allows for an infinite number of permits at
that price
Transportation demand is inelastic
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Australia’s solution -- cap the permit price at some level
See above.
Can’t have a cap on each driver
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But, you can set it at the refinery level (for carbon)
For other pollutants, such as NOx, would require making
assumptions on “typical” driving habits
Alternatives
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Pollution: technology forcing (standards)
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National defense: CAFE standards, LCFS, subsidies
(negative taxes)
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Climate Changes: LCFS, subsidies
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Congestion: HOV lanes
New development in CA
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LCFS exciting new development
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Holland, Knittel and Hughes (2007) work through the
incentives of the firms:
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Firms face a carbon intensity rate constraint
Essentially: taxes fuels with carbon intensities above the
standard, but subsidizes fuels with CIs below
All this is internal to the firm, so we never have to say “Taxx”
Can get the relative prices “right,” but low carbon fuels
will be too cheap
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Used as to solve other market failures?
(Indirect) network effects
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E.g., hydrogen automakers need hydrogen refueling stations,
hydrogen refueling stations need hydrogen automobiles
Exists in many industries – any hardware/software industry
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So-called chicken and egg problem
Blueray/HD-DVD player manufacturers need content,
content providers need players
• This is the reason why Betamax died!
Mall store #1, needs mall store #2, and vice versa
Here, fixing the prices may not be enough (not completely
true)
S = marginal social
cost
P
P*
marginal social
D = marginal
benefit
private benefit
QNet
Q*
Q
What do we learn?
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Network effects can lead us to get “stuck” at a nonoptimal equilibrium (Windows?)
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We can also switch to a non-optimal equilibrium
• Largely depends on consumers’ expectations
How do we solve them?
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They occur because each side of the market doesn’t
“internalize” the benefit to the other side
The obvious solution is for the two sides to “merge”
Alternatives:
• They can coordinate, policymakers can set up consortia
• Policymakers can set mandates
• Suboptimal prices
Market power – the good market failure?
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In almost every other industry, the market failure we
worry about most is market power
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Market power occurs when a firm’s output decision influences
price
When this is the case, the firm no longer views its marginal
revenue (revenue from selling one additional unit) as equal to
the price
• Why? Because in order to sell one more unit, the firm must
lower the price on all of the existing units
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Market power drives a wedge between price the social
marginal cost; the supply curve is no longer the MC curve
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So, we have “deadweight loss” from under consumption
Sources of market power in transportation
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OPEC/Extraction
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Cartels exist to increase market power
Shipping (?)
Refinery Industry
Retail Industry (probably small)
In theory, market power and negative externalities can
fully offset each other
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For example, if P=60, MPC=10, Negative Externality=50
Damage from CO2 ($/MTCO2)
Can they cancel? Just for fun…
MC of a Barrel of Oil
0
10
20
30
40
50
60
0
60.00
50.00
40.00
30.00
20.00
10.00
0.00
40
40.00
30.00
20.00
10.00
0.00
-10.00
-20.00
80
20.00
10.00
0.00
-10.00
-20.00
-30.00
-40.00
120
0.00
-10.00
-20.00
-30.00
-40.00
-50.00
-60.00
160
-20.00
-30.00
-40.00
-50.00
-60.00
-70.00
-80.00
200
-40.00
-50.00
-60.00
-70.00
-80.00
-90.00
-100.00
240
-60.00
-70.00
-80.00
-90.00
-100.00
-110.00
-120.00
280
-80.00
-90.00
-100.00
-110.00
-120.00
-130.00
-140.00
Where do we go from here?
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Unfortunately, the easiest and most direct way to solve many
of the problems inherent in energy markets may not be
politically feasible
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Most of the alternatives create perverse incentives
somewhere
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But, we shouldn’t stop trying
(If not, they would be the preferred choice)
These perverse effects require additional policies, which…
We can’t lose trust in markets
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Energy markets are failing, for the most part, because the prices are
wrong
We can’t use arguments like “they’ve never worked in the past, so they
won’t work in the future”