March 2004 Archives

Nick Schulz from TechCentral Station and Transition Game has an article in today's National Review Online, in which he discusses gas prices and Kerry's energy policy suggestions. In addition to referencing yours truly, for which I am exceedingly grateful, he makes a lot of good points about these subjects and how likely Kerry would be to succeed in achieving his proposed policies.

More on OPEC's new attempt to restrict its production and the federal government reactions, from the New York Times (link courtesy of Megan McArdle), Forbes, and PBS's Newshour Online.

Many thanks to Virginia Postrel for the link. Note that she observed a reduction in driving in LA in this period of high gas prices. Yes, the demand for gasoline is inelastic, but it's not vertical/perfectly inelastic!

Note also her post that suggests that it could be 1996 all over again in terms of the oil policy debate. I feel obligated to point out that 1995/6 was when Phase II of the oxygenate/reformulated gasoline regulations under the Clean Air Act Amendments of 1990 were implemented? Coincidence?

I'd also like to hear from John Kerry some more specifics on what he thinks constitutes "normal" gas prices, and how he would propose to keep from having "normal" gas prices as "low" become a political expectation that politicians feel they have to deliver, regardless of the economic inefficiency, environmental implications, and other effects of artificially managed gas prices.

OK, now I have to do some work!

Last night there was an explosion at the third-largest petroleum refinery in the US. Fragmented fuel markets as a result of the patchwork of 40+ fuel formulations in the US to meet federal+state air quality reguations has created an environment in which our refinery industry has little fault tolerance. Put another way, when unexpected stuff goes wrong, because we can't just substitute more stuff from somewhere else, quantities don't adjust so prices have to. Thus price spikes.

Let the demagoguery begin! Let it know no bounds, nor be the private purview of either major political party.

One the one hand, John Kerry makes several "proposals" for reducing gas and oil prices, which are of course President Bush's fault, ably summarized in this Houston Chronicle article. Kerry's suggestions are laughably unrealistic and unlikely to make a substantial difference in world petroleum markets. The two main suggestions are for the Administration to use moral suasion to persuade OPEC not to reduce output, and for the Administration to discontinue additions to the Strategic Petroleum Reserve. The former is guffaw-producing, the latter is quite literally demagoguing an activity that is a drop in the bucket. Note, though, this Forbes article lists one of his recommendations as reducing the number of fuel formulations to satisfy air quality regulations. So there is a soupcon of sense and substance here, but getting to it through the bluster, pandering and rhetoric is nigh-on impossible.

On the other hand, the Bush Administration argues that had Congress passed an energy bill three years ago, gas prices would be lower today. There is actually a glimmer of substance behind this particular demagoguery, for the reasons Barry Posner laid out last week: all of the energy bill proposals of the past three years would have reduced the number of fuel formulations required in the US to meet air quality regulations. That increase in fungibility of refined product supply would have re-introduced some flexibility into fuel supply. The main drivers of high prices today are crude oil prices and refinery capacit constraints, which are reinforced by the complex and ever-changing regulatory environment. But still, the shrill tone yesterday was one of "don't blame us, it's Congress's fault!"

But in the end, I think Severin Borenstein is right in what he said in an article in the San Jose Mercury News:

"There's really just not that much that the U.S. president can -- or, in my opinion, should -- do to pressure OPEC,'' said Severin Borenstein, director of the University of California Energy Institute. "It is their oil. They have a right to sell it or not to sell it.''

If the price were adjusted for inflation, a gallon in California still would be cheaper than in 1980: $2.41 in today's dollars.

And kudos to Laura Kurtzman for noting the real/nominal price distinction in her excellent article!

The SPR injections are a small and cheap insurance policy, an occasionally useful ballast against a cartel with occasional abilities to exercise its market power (that would be OPEC, right now). The SPR has been used in the past to political ends, most recently by President Clinton to reduce domestic gas prices before the 2000 election.

Recall that today is the day that OPEC decides whether or not it will reduce its output. Even after the application of some moral suasion from the US, OPEC has apparently agreed to a cut of 1 million barrels per day. The 800-pound gorilla in the neighborhood, Saudi Arabia, is pushing this because of its domestic budget needs.

If, as OPEC claims, speculative investment funds are driving the increase in world oil prices (I'm not convinced), then some are likely to cash out at these prices. That is one factor that could contribute to a reduction in oil prices.

Another is the extent to which high oil prices induces increased production from non-OPEC suppliers, particularly Russia, Mexico, Norway, and Canada. Most Americans do not realize that our largest oil supplier is Canada. No, not largest after Saudi Arabia -- largest, full stop. As my friend Terry Barnich argued at an Illinois-Canada trade conference I attended last Friday, thinking of North America as an integrated energy market and improving oil and natural gas delivery infrastructure (such as pipelines) would enhance our energy trade from our closest neighbors, and reduce OPEC's market power. That's a more constructive and concrete recommendation than trying to persuade OPEC to stop; the most persuasive way to make OPEC stop is to stop buying from them. Vote with our dollars instead of whining.

One more potential means of reducing oil prices is the cheating that is inherent in OPEC. Small producers can piggyback on Saudi Arabia's cut by saying they'll reduce and then not reducing. That increases their profits with little impact on price. But as prices rise, the temptation to cheat rises too, and as more cheating occurs, it has a larger impact on price. That is the primary dynamic through which cartels are inherently unstable, and through which OPEC has given us boom and bust cycles of oil prices over the past three decades.

A guest post from my colleague Mike Giberson:

In response to your ENOUGH ALREADY ON "RECORD HIGH" GAS PRICES, note that the Washington Post does, on occasion, adjust for inflation in its commentary on gasoline prices:

For one, it is worth pointing out that gasoline prices, while higher than a few years ago, are still well short of their historic highs. Adjusted for inflation, gas prices are still significantly lower than they were at the beginning of the 1980s, and they have been at historical lows for the past decade: No wonder demand is high.

In fact, the Post almost always gets a few things right as it bounces along to an erroneous conclusion.

Given the hidden costs of high fuel consumption - pollution, urban sprawl, time wasted in traffic - it can be argued that this country has paid a high price for not having higher fuel prices. A price rise now hurts people all the more because they have made choices - living in distant suburbs, driving large cars - predicated on low fuel prices. That fact, to no small degree, is the fault of this administration, as well as those that preceded it, for not having had the courage to wean the country off low-priced fuel when it would have been easier to do so.

The conclusion seems to raise more questions than it answers. Let's do a little Q and A:

Q: When were those "good old days" when it would have been easier to wean the country off low-priced fuel?

A: From the logic of the sentence they were during "this administration, as well as those that preceded it," so I'm guessing that they start in the last year or two and then in prior years.

Q: So, when were those choices made - to live in a distant suburb, to drive a large car - predicated on low fuel prices?

A: Well, they must mark the end of the "good old days" period, because once the decisions were made a "price rise . hurts people" and it is no longer easy to "wean the country.." We know this was just in the last year or two, otherwise "this administration" wouldn't have to share the blame for a lack of courage with "those that preceded it."

Q: What can we conclude from all of this?

A: My guess is that the Post editorialist bought a Lincoln Navigator and moved out to Potomac in the last year or two.

Run, don't walk, to back40's house at CrumbTrail to read this post and the article to which he links on the dubious reasons for claiming that biofuels are renewable.

It has bothered me for a long time that no one has really quantified the entire supply chain in modern biofuels, including all of the attendant energy flows in producing fertilizer, transportation (which for things like ethanol is substantial because ethanol is the fragile flower of the fuel world), and so on. This article and post at least point us in that direction, although much, much more analysis is required.

OK, I'm going to rise to Ray Gifford's bait, being the new institutional economics econ-geek that Ray believes me to be ... the essay that he links to by Eric Gunning on the potential and the pitfalls associated with Coasean bargaining is a good, concise treatment of the subject. I encourage you to follow his link and read it.

On the baseball front, if I were Ray I wouldn't be slingin' too much mud, especially since it looks like the worst pitcher in the Cubs rotation in 2003, Shawn Estes, will be the opening day starter for the Rockies. I cringed every time he walked to the mound. Sorry, Ray, I feel for ya, buddy!

And in any case, pitchers are not in my shrine; I'm a Moises Alou woman! Although according to the New York Times, the Cubs have the pitching staff to beat this year ...

I owe a ginormous (as Trinny and Susannah would say) debt of gratitude to Brian Doss at Catallarchy for posting the link to this online FAQ about the labor theory of value. The students in my next history of economic thought class will be the most appreciative though, because they're the ones who won't have to struggle as much with these concepts as previous students!

I am really glad that folks around here have picked up this bundling conversation. See, for example, Stephen Bainbridge's observations, who argues that bundling is anticompetitive. I disagree, as long as the consumer has an opportunity to say "no" and use something else. And of course under the usual dynamics of R&D and competition, some people will be happy with IE, others will not, and as long as there is diversity of preferences, a monopoly browser is unlikely to exist in reality.

Not surprisingly, Brad DeLong feels he's been harmed by Microsoft too, and argues accordingly. The comments on his post are particularly interesting, especially the one from Phil Hallam-Baker, who was on the original web team at CERN.

Alex Tabarrok has a great post from this morning on the topic, focusing on Brad's argument that he's been harmed. Alex's argument does three important things: it focuses us on the fact that when goods have complementarities and we don't allow bundling, if both markets develop into monopolies then you have the double monopoly or double marginalization problem, which is a textbook recipe for deadweight loss and a decline in consumer well-being. He also brings in the fact that vigorous competition for browser market share is a form of R&D-based franchise bidding, in which the competitors know they are competing for a large and stable market share. Alex's argument also reminds us of the importance and value of contestability, which a lot of the pro-regulation voices on this topic discount, incorrectly I believe.

Arnold Kling also has a post on the subject, correctly noting that bundling is all around us, always has been, and has value to consumers. He concludes:

Regulators could argue that bundling by Microsoft or the cable companies needs to be regulated because those companies have monopoly power. But I would rather see product specifications and pricing set in a market, however imperfect, than set by a government bureaucrat. At best you are exchanging one uncompetitive decision process for another.

I do not see any way to preserve the free market system if you decide that bundling provides a rationale for regulation.

Consumers making choices decide on the optimal degree of bundling. Some of them are large consumers that move the market share and the bundling more toward single provider (like the federal government's procurement decisions on its computers). But we can still say no, and we have options.

Phil Hallam-Baker is right, that Microsoft did get ahead in the browser part of the value chain by building a better browser. That is no longer necessarily the case. Note IE's absence of tabbed browsing, for example, which is a great organizational tool when you have to have lots of pages open.

In my case, the only time I use IE is if a page is not loading properly in Mozilla. Uusally it involves Java script problems. No biggie.

BTW, do the Movable Type folks know that the little url/bold/italic/underline macros only show up in IE? I hard code everything on this blog b/c the cute little buttons at the top right only show up when I use IE. Not worth it. But if the MT folks want to improve MT, having the macros work with more browsers would be good.

In a comment on one of my gasoline posts below, Barry Posner made some great observations about refinery capacity that are so good that I'm going to pull them out and post them here. I have been abstracting from refinery capacity in recent discussions of gas price fluctuations, because it has been a constraint for the past decade and will only become more of one. Here is Barry's analysis:

Lynne:

Unless I missed it while reading this article, I think you overlook another important factor: capacity constraints in domestic refining capacity. We all know that the last new refinery in the US was built in 1976, and that many small refiners are forced to shutdown because capital improvements are not economic given RFG requirements.

This is partly due to NIMBY in the US, and is exacerbated by the patchwork RFG requirements and boutique gasolines: if there was a standard blend, we could simply buy more gas from refineries in places like the Virgin Islands, Dominican Republic, Jamaica and (in the near future) Cuba. We wouldn't necessarily need new refineries on mainland US soil - but the boutique fuels make such projects more risky than they otherwise would be.

Reducing the number of blends required would ease short-term local spikes caused by localized refinery and pipeline outages (which will happen, random as they might be), and would encourage more refinery construction in the Caribbean, which would add some excess capacity (which is currently zero in the summer), thus dampening non-localized (natiowide) summer supply crunches.

New vehicle technology has made the 1990 revisions to the Clean Air Act very close to redundant. Now, if only we can get those revisions reversed without a giant handout to the ethanol producers...

My favorite movie of all time is being re-released! Monty Python's Life of Brian will be re-released at the end of April.

The producers say they are doing this as a "Passion of the Christ" antidote. I don't care why they're doing it just that they are! I've only ever seen it on the big screen at midnight movies, which means poor quality video and audio. I wanted to go see it when it was released, but my parents wouldn't let me; apparently they thought it might not be appropriate for a 12-year-old, no matter how warped a sense of humor she already had ...

I can't wait!!!

Of course, the best line in the whole thing?

"Yes, we are all individuals!"

"I'm not."

"Ssssh!"

An article from the Minneapolis Star-Tribune on how the inflation-adjusted price of gasoline is not at a record high. Note his last quote from a source: "The market is going to take care of this."

BTW, I agree with Kevin Brancato's comment here last week, laying some of the responsibility for the economic illiteracy of the populace and of journalists at the feet of so-called "experts" like AAA. I think they should do a much better job of framing and contextualizing gas price changes than they do.

Jerry Taylor of Cato wrote a commentary decrying OPEC, laying out OPEC's role in keeping oil prices high. He's completely right. One interesting point that he makes is that cartel prices can be more volatile than normal market prices, which is going to mess with the heads of folks who are scared of markets because "they are volatile":

Cartel prices fluctuate more because they are less certain than normal market prices, inviting speculation. In short, market agents are forced not only to consider global supply and demand but also to factor in OPEC's behavior and its members' fidelity to their promises. Hence, the market is less predictable and prices are accordingly more volatile.

Good point. I would only add that he should take into account contestability, and that potential competition from non-OPEC sources like Russia, Norway, Mexico and Canada are going to become increasing substitute supplies for OPEC oil.

OPEC's meeting to decide on its strategy for next quarter takes place on Wednesday.

C'mon, people, doesn't anyone know how to use a GDP deflator? Certainly the journalists writing articles like this at the Washington Post and the various and sundry wire services that have been feeding hyperbole to their readers have demonstrated their complete and utter inability to process the difference between real and nominal prices. Why don't they get into such a tizzy and print articles on how our incomes have reached record levels?

Grr.

Meanwhile, here's an interesting New York Times article on investment in drilling for oil and natural gas in the Gulf of Mexico, considered to be pretty dry. In this case the author makes the correct observation that as prices rise, investment in exploration goes up. He also highlights the role that technological change has played in enabling oil explorers to get product out of places that were impossible before.

I'm glad to see that not all journalists writing about this industry are economic thickies.

I had two students last quarter who are econ/journalism double majors, and I think they were mystified by why I kept encouraging them so vigorously, saying things like "we really need people with your combination of skills!". This current gas price situation provides yet another data point supporting that argument.

UPDATE: Clearly Steve Verdon and I are both bugged about this, as indicated by his almost contemporaneous post on the same topic.

This Technology Review article on hybrid and hydrogen vehicles explains why hybrid vehicles will have commercial dominance over hydrogen for the forseeable future. It's a good read, one that I wanted to comment on anyway and an intrepid reader alerted me to as well.

The argument in this story also makes a lot of the same points as I did in "Let the Hydrogen Economy Evolve", a five-part series of articles on hydrogen at Reason Public Policy Institute.

Check out this oil price primer from Frederick Leuffer in the National Review. Lots of good information there. I particularly like that his answer to "are we running out of oil?" is a curt "No".

According to lots of news over the past couple of weeks, that's what a lot of folks are doing. Forbes, for example, had this feature on "pump-busters", where they showcase fuel efficient vehicles of all types and sizes. They also break down the component costs of a gallon of fuel:

But what exactly are you paying for? According to the U.S. Department of Energy's Energy Information Administration (EIA), every time you slip a nozzle into your gas tank, 43% of your outlay is for crude oil. Taxes are the next biggest chunk (26%), followed by refining costs (23%). The remaining 8% is to pay for distribution and marketing.

And in St. Petersburg, Florida, gas prices are leading consumers to shop for hybrid vehicles.

Knox Wimberly, sales manager for Palm Harbor Honda, said interest in the gas-stingy cars has surged along with gas prices, which hit another record high Friday in the Tampa Bay area: $1.717 for a gallon of unleaded fuel, according to the Automobile Association of America.

"We've given away every single brochure we have on the vehicle," Trachtenberg said. "And every single Prius built for the next eight or nine months nationwide has already been sold."

The American International Automobile Dealers Association confirms this experience.

One of the refreshing and creativity-inducing things for me about the Internet is reading well-written essays by people who think about the same kind of issues as I do, but with their own perspective and je ne sais quoi.

I reveled in such a find yesterday, upon reading The Idea Shop. There Andrew David Chamberlain has already discussed such important and interesting issues as water policy, the fable of the bees, why we don't run out of oil, and the transaction costs facing startup businesses in developing countries. And he does so with a a voice of simultaneous clarity and wonder -- clarity from simple, elegant explanation of economic dynamics, wonder at the fantastic complex system of mutually beneficial exchange.

Thanks to Newmark's Door for the pointer.

Being systematic, here are the primary reasons for the rise in gasoline prices in March 2004:

1. High world crude oil prices. These prices are partly the consequence of conscious OPEC supply constriction to raise price. OPEC’s ability to do so is typically constrained by three interrelated factors: the world demand for oil, cheating on the part of smaller OPEC members, and production from non-OPEC countries like Russia, Norway and Mexico. Economic growth, particularly in Asia, is shifting out the demand for oil according to this Ft. Worth Star-Telegram article:

Strong demand for oil in Asia is one reason for higher crude prices in recent months, although analysts also said that aggressive bets by large commodity speculators have contributed to the recent run-up in oil markets. Much of the attention on Asian oil supplies is related to the fast-growing economies of China and India.

Sales of diesel fuel in India, which account for about 40 percent of the oil sold in that country, soared 10 percent in February from the same month a year earlier; automobile sales in India grew 31 percent in the last year. India's oil imports are forecast to continue to climb as its economy grows 8 percent this year.

This Investor’s Business Daily article points to the other two aspects of this dynamic: Saudi Arabia is still the “swing producer” because of the scale of its reserves relative to other producers, and some OPEC members have not curtailed production to meet the targets OPEC set in their 1 February meeting. Saudi Arabia’s production is the primary determininant of the world price, and with rising demand the growth in production in Russia and in Iraq has not been sufficient to change that fact. And small OPEC producers are riding the crest of this high price, not restricting their output.

No current discussion of OPEC is complete without reference to the horrendous state of affairs in Venezuela. Their low production adds substantially to the high prices we are currently experiencing.

OPEC is currently discussing whether or not to continue its output restrictions at the end of the month, and today’s news suggests that they are fighting internal battles over whether to pursue output restrictions when their benchmark price is $4 above the high end of their usual benchmark range.

2. Existing environmental regulations making supply more inelastic. Petroleum refiners in the US must meet the EPA’s federal fuel oxygenate requirement from Title II of the Clean Air Act Amendments of 1990, which mandates a 2% oxygen content in fuel in ozone non-attainment urban areas. Furthermore, refiners are required to drain all of the winter fuel from their tanks before replacing it with summer fuel, which in most markets must have inventory built up to start sales on 1 April. On top of that, states can choose to implement their own fuel formulation requirements to address their specific geographic and climatologic conditions that lead to different local air quality conditions. As a result, the US now has over 40 fuel formulation requirements at different times and places.

Think about what this does physically and economically. People continue driving in March, and continue to use winter-blend fuel while the inventory of winter-blend fuel falls, ideally to zero at midnight on 31 March. Inventory storage costs are very high for petroleum, so keeping a buffer of winter fuel through March and over the summer is very expensive (this point is in response to a question from Virginia Postrel on storage). Not only do people generally not want new refineries built near them, they also do not want new tank farms built near them. So storage capacity is a binding constraint.

So of course the seasonal fragmentation that the oxygenate requirement introduces into fuel supply would cause prices to rise in March, all other things equal. This temporal fragmentation exacerbates the balkanization of fuel markets, because of the 40+ fuel formulations in effect. Note especially that this fragmentation across both time and place makes the supply of gasoline more inelastic. Confront that with an inelastic demand for gasoline, and one that shifts out and becomes more inelastic in the spring and summer months, and you have a policy-driven exacerbation of the potential for price spikes.

The California prices are also driven by the switch from MTBE as fuel oxygenate to ethanol, a switch that is taking full effect for the first time in 2004. Ethanol, a corn-based additive, is not produced in California, cannot be shipped from the Midwest to California in oil pipelines, and is highly water soluble, so it can only be added to the fuel at the rack (basically, right before it ships out to gas stations). And Senator Boxer wonders why the price of gasoline in California has gone up to $2.18/gallon? I suggest that she review Title II, Section 211 of the Clean Air Act Amendments of 1990. You can also read my testimony to a Congressional hearing on the MTBE/ethanol transition in California from July 2003 for more background.

3. New air quality regulations taking effect in 2004. The EPA’s Tier 2 sulfur control regulations, leading to the co-development of low-sulfur fuels and vehicles optimized to the use of low-sulfur fuel, took effect in January 2004. This program to reduce sulfur content in fuel will be phased in over three years, and 2004 is the first year in which refiners will be required to meet overall sulfur content regulations, according to this EPA fact sheet on the Tier 2 regulations:

Beginning in 2004, the nation’s refiners and importers of gasoline will have the flexibility to manufacture gasoline with a range of sulfur levels as long as all of their production is capped at 300 parts per million (ppm) and their annual corporate average sulfur levels are 120 ppm.

More information on the regulations is available at the EPA OTAG Tier 2 website. The Tier 2 regulations can be found in the Federal Register from 2000.

These new regulations, while likely to deliver improvements in air quality, are going to increase gas prices, at least in the short run. Refiners are having to engage in research, in reconfiguration of their production processes, and in equipment installation to meet the new low-sulfur requirements. For example, Valero is building a new desulfurization unit in one of its Louisiana refineries, precisely to aid compliance with the Tier 2 sulfur regulations.

These factors have combined to raise the current, and expected future, prices of gasoline. The new low-sulfur requirements are not likely to exacerbate the seasonality/inelasticity problem, but they will increase fuel prices.

In spring, our thoughts typically turn to … the seasonal increase in gasoline prices (what did you think I was going to say?). It all started with this New York Times article on 6 March, which noted that consumers are complaining about high and rising gas prices. They concisely summarized the most apparent causes of the price increase:

Reasons for the increases include prices for crude oil, which sold for a high of $37.45 a barrel on Friday on the New York Mercantile Exchange. Worldwide supply of crude appears to be tight, partly because O.P.E.C., the world's largest oil cartel, plans to cut production next month and because of political and industrial turbulence in Venezuela, a major provider of oil for the United States.

In addition, many refineries in the United States are changing over to production of so-called summer fuels, an expensive process in itself, and refinery operators say they are also having to pass on some of the increased costs of producing gasoline with newly mandated levels of oxygenates, primarily ethanol.

Tyler Cowen picked up on this article in his discussion of whether or not to boycott gas stations. Tyler related an important fact from his reading of a recent Gregg Easterbrook column: in real terms, the current gas price is well below the all-time high, which occurred in 1981. Then Steve Verdon picked up on Tyler’s thread with a couple of posts, including a reference to this SF Chronicle article that discusses the increase in gas prices in California, and Senator Boxer’s request for an FTC investigation:

Various investigations of the oil industry have failed to find any illegal market manipulation during earlier spikes. The most recent state inquiry, concluded last year by the state Energy Commission, found nothing amiss.

"Our industry had a profit margin of about 6.3 percent and all industries are at 6.7 percent" for the fourth quarter of 2003, Sparano said. "That's not excessive."

That profitability fact is important, because it is consistent with the hypothesis that the root cause of higher gas prices is fuels regulation. The seasonal pattern of price changes is also consistent with that hypothesis. The profits in the petroleum refining industry being not too high on average also suggests that Bill Lockyer is misguided when he worries about a “lack of competition”, particularly given these data:

One of Lockyer's chief complaints about California's gas market is what he calls a lack of competition. He said that seven oil companies control 98 percent of the state's refining capacity and then market 90 percent of the gasoline they refine through their own service stations.

Seven is a pretty big number, especially when you are discussing an industry as complicated, capital intensive, and regulated as petroleum refining and marketing. Put another way, oligopolies can be very aggressive and competitive, and just going by the number of firms in an industry is a naïve and unsophisticated approach that is certain to lead to bad “competition” policy. My opinion, YMMV, so to speak.

Last week Northwestern Newsfeed interviewed me about gas prices. You can find the transcript and the audio feed at the Northwestern Newsfeed website.

In a separate post I will analyze the causes of the current increase in gasoline prices.

My good friend and mentor Joel Mokyr spoke with Forbes recently about the most influential businessmen in history. The resulting article and list of people is quite interesting. To read each, click through the list on the right side of the article.

The list contains two of my favorite entrepreneurs and two of the Lunar Men, Matthew Boulton and Josiah Wedgwood. The entry on Wedgwood is quite right to remark on his invention of the celebrity endorsement, but there's so much more to him than that. Wedgwood pioneered the use of showrooms to display his wares, making them stylish and elegant. He pioneered the use of standard shapes in his product lines, and the communication of the shapes and finishes through what we would now think of as catalog advertising. And he introduced the money-back guarantee to retail.

Not to mention the beauty of his products, which continues to this day.

Tyler Cowen reminds me in one of his posts today that I don't link to Ben Muse often enough to reflect the value I get from reading his website.

I'm doing a little housecleaning today, so you'll see Ben added to my links list, as well as Fellow Chicagoans Milt Rosenberg and Theresa the keyboard biologist and knitter. Theresa and Bonne Marie Burns are habitues of a KIP (that's knit-in-public to you) every other Thursday that I keep trying to get to. Maybe next week it'll finally happen, since it's spring break.

While we're on the Chicago theme here, I've been meaning to post this Design Within Reach newsletter from February. DWR is opening a studio in Chicago, and to celebrate that opening they featured this article on the Chicago Architecture Foundation. CAF (of which yours truly is a member) hosts architecture tours in Chicago and suburbs, has a great gift shop, and provides a wonderful docent volunteer opportunity for people who love Chicago architecture and want to share that love with visitors:

Every day of the year, with the exception of a few holidays, a design tour is being led by this group, educating locals and tourists alike on the cultural relevance of design. They offer more than 50 tours that range from Churches by Bus to Frank Lloyd Wright on Tuesdays to Winnetka by Bike. ... But the defining characteristic of the CAF is the very manner in which the design history is delivered to the public: by riverboat, by rail, by foot, by bike and always in person.

Ditto on my being a spaz: check out Global Chicago, written by Michael Herman, a fellow Chicagoan. He takes a philosophical approach to design and urban space, which I find refreshingly different to read and think about. I am intrigued by his take on open space, complexity, and Hayek:

The planned orders of our organizations simply can not handle the levels of complexity and adaptation that most organizations are facing. The only compassionate thing to do is look carefully at the knowns and unknowns... and then to use planned orders for what we know and use OpenSpaceTech to discover and invite spontaneous orders to address all of the real and uncertain complexities, diversities, urgencies and conflicts we face.

Lots of food for thought.

Am surrounded by approx. 400 pages of environmental economics research papers. Very interesting reads and lots of good research done. This and other factors of the day jobs have contributed to the silence in these quarters this week. Should change soon.

So today I looked in my "junk" folder in my mail program, and found several emails there that are "not junk"! The negative externalities of spam, indeed.

One such message was from Mike VanWinkle, editor of Chicago Report, a blog-zine focusing primarily on Chicago politics and culture. I had, of course, seen links to Chicago Report in other places, and have been reading it, but I wanted to put a formal "Hi!" here.

Hi!

Randall McElroy at Catallarchy has a really nice post from Sunday on the construction and use of public transportation in Atlanta and Chicago. One thing that matters is history -- when the city builds its transportation infrastructure. But his point is well taken, and it's not only public transportation that was privately funded by early adopters. I like his conclusion:

These two cases indicate something very important for city planners. First, if a city demands mass transit, private enterprise will supply it. Second, if a city does not demand mass transit, building it anyway (publicly, since private enterprise does not supply what is not demanded) will result in a system so poor that few people want to ride it and that can only survive on continuous 11th-hour rescues with tax dollars. Either way, we will get from point A to point B without you.

According to this New Scientist article, feeding rapeseed (canola) oil to cows can produce butter with a better balance of unsaturated fats.

Apparently the proportions in the feed have to be handled delicately, as the cow's rumen (forestomach) contains bacteria that don't respond well to the presence of so much canola oil.

I wonder if this would have any effect on bovine methane production ... one of my student groups is doing a research project on livestock methane production and greenhouse gases in the southern hemisphere. Better butter and less gas might be asking for a lot, but ... strive for it!

Stephen Bainbridge has an interesting post on Petite Sirah, one of my favorite grapes. I like the blackberry and boysenberry that he notes in the young PS, and I certainly like the chocolate and spices in the mature PS. It's a yummy and versatile grape, especially if you cook on the grill a lot.

He mentions that he has Ridge PS from the mid-90s that isn't even close to drinking. We are going to have to be even more patient; our cellar has a few 1998, 1999, and 2000 Petite Sirahs from Preston Vineyards in Dry Creek Valley, Sonoma County. We have opened a couple of them, and they were good after decanting, but still had tons more potential.

For an instant gratification, cheap-and-cheerful Petite Sirah to go with the grilled lamb chops without having to wait 15 years, try the PS from Bogle Vineyards. It retails around $10, is a gorgeous deep purple, has those blackberry and boysenberry and spice notes, and is an accessible way to get acquainted with this fantastic grape and decide if you want to invest in the Ridges and Prestons of the world.

This post from Tyler Cowen from Saturday illustrates some interesting features of our water use over the past 30 years. Evidently, our aggregate water use has not changed in 20 years:

The flat trend in consumption came even as the USA's population grew and electricity production, the largest user of water, increased.

Of course, one of the cool things about hydro power is that you can reuse the same water over and over again, by pumping it back up to the top at night when it's cheap to generate power to do so. That's called pump storage. But I digress ...

What amazes me is that this decrease has come notwithstanding the fact that water is one of the most illogically and inefficiently priced and used resources on the planet.

Tyler notes that 70 percent of water use is in agriculture, and at least in the US, a lot of water gets used in agriculture that may not be needed because of the lack of transferability between potential uses and the "use it or lose it" bureaucratic mentality that has overtaken the interpretation of historic water rights. In my ideal world, the historic water rights that farmers have would be a fully transferable and alienable property right. So if San Diego, for example, is willing to pay more for water than the value that the water represents to my crops, then I'm gonna sell. Such transactions can't really happen now, so we get locked into inefficient and non-value-maximizing uses of water.

Put it another way: our water use has not gone up in 20 years. If we paid prices for water that reflected the true cost of its use, and if farmers could transfer their property rights over water to non-agricultural users, think how much less water we could be using than we did 20 years ago.

I also think Tyler's point about nanotech desalinization is pretty cool. So in my lifetime I could have a Nalgene bottle with a filter that would turn salt water into fresh? Sweet! La vita e bella.

COTC is at TJ's Weblog this week. I was particularly intrigued by this Geitner Simmons entry interpreting some recent import and export statistics. Who knew that almost half of the lost US exports since 2000 have come from California? That helps to explain some of the economic malaise there. And the Department of Commerce website that he uses to generate these facts is absolutely fascinating. It focuses only on products; I'd be curious to see what the numbers look like for services too.

I also recommend Steve Verdon's post on the cost of environmental regulation. It's interesting that the examples he's responding to are of petroleum refining, because of the popular misconception that petroleum refiners have pretty serious market power and enjoy commensurate profit margins. Having looked at the financial data for this SIC code for the past 20 years, I can assure you that this is a misconception, that petroleum refining is not that profitable relative to the return on equity in other industries, and that its industry structure is actually such an aggressive oligopoly that they tend to compete away all "excess profits". So Steve's post helps to make sense of why firms would exit a seemingly profitable industry.

OK, off to, as P.G. Wodehouse would say, earn the weekly envelope.

On Tuesday Stephen Karlson asked why our seasonal gasoline price spikes persist:

The $100 bill left on the sidewalk is this: why does the transition from winter gas prices to summer gas prices continue to have this price spike, year after year. One would think there is some money to be made in the right kind of hedging and stockpiling. Or is the real cost of tankage so high as to preclude such strategies?

Stephen answered his own question, and correctly. The existing EPA fuel oxygenate requirements that arise from the Clean Air Act Amendments of 1990 require that all refiners deplete their inventories of winter fuel before restocking the tanks with the summer fuel (something to do with reducing the probabiilty of mixing). This requirement exacerbates the seasonality that is inherent in gasoline prices because of (1) changes in the demand for gasoline and (2) the price inelastic nature of the demand for gasoline. So now in addition to inelastic seasonal demand for gasoline, we have inelastic seasonal supply of gasoline. And politicians and "uninformed newscasters" wonder why we have seasonal price spikes ...

In theory these price spikes should provide an arbitrage opportunity for some clever entrepreneurs. But the opportunity cost of inventory storage is very large; petroleum refining is a very aggressive oligopoly, so the profit margins are just not there to support carrying such a capital cost. Furthermore, constructing more tank farms is almost as much of a no-no from the aesthetic/NIMBY perspective as building more refineries (the last refinery built in the US was constructed in 1976, in Louisiana). So expanding storage is expensive and difficult to achieve.

That's why it's not a $100 on the sidewalk. But it is a deadweight loss from the ill-conceived and poorly implemented regulations to control the emissions from burning gasoline.

But is there a better way, you ask? I think the fuel oxygenate requirement is another entry in the list of bad input regulations to try to control outcomes. A much better approach is to say, "We're gonna sniff the tailpipes of cars burning your fuel. If the pattern of their emissions of criterion polutants does not meet our emission standard, then you are susceptible to a fine. Now go and set your engineers to solving this problem." No telling the refiners how to do their jobs, no technology mandates, no input mandates that ignore how costly it is to re-engineer your refining process to meet the mandate. You just have a goal, a desired outcome, and you use your local knowledge and your human capital to meet it.

I did a search of my archives, and found posts over the past two years on gasoline prices, if you are interested in seeing what I've written on them in the past.

What a beautiful place ... my husband flew to London and we sandwiched in a couple of days of hiking in the Peak District. And except for the vividly colored foliage, which is not in bloom in early March, it pretty much looks like that picture.

We did 10 miles of hiking both days. The first day we did dale (valley), village and meadows as we hiked around Monsal Dale, up over Monsal Head at the top of the dale, through the surrounding fields, and down into Ashford in the Water, a very beautiful village.

We stayed in the Monsal Head Hotel, which is completely charming and we can recommend to one and all. The restaurant in the hotel is outstanding, and the pub has a constant rotation of different hand-pull beers. The staff are friendly and funny. We stayed in the room just over the door in the picture, so consequently we had this view:

The second day we did basically this hike up from Derwent Dam across the moor and along Derwent Edge. This was an amazing hike. The scenery was gorgeous, with rolling hills and sheep at the start, climbing to rough and craggy moors covered with scrubby vegetation that hunkers down to the soil and takes the brunt of the wind. Then at the top the soil becomes very carbon-rich, and you feel like you are walking through incipient coal (at least in a few hundred thousand years!). The gritstone rock formations along the Derwent Edge are very cool, especially if you are a rock formation fan as I am; you can see some of them by clicking on the pictures in the link earlier in this paragraph. And since you walk along the ridge, the view to the west opens up over the reservoir to the hills on the other side. Just spectacular.

On our way out of Derbyshire we, of course, had to stop in Cromford, which I and many others consider to be the birthplace of modern economic activity. Cromford is the site at which Richard Arkwright, a cranky but ingenious wigmaker from Preston, set up the first modern large-scale cotton textile production facilities. While in the process of inventing the water frame (in intellectual and financial partnership with others, of course), following on his 1769 patent, Arkwright built Cromford Mill in 1771:

Arkwright's Spinning-Frame was too large to be operated by hand and so the men had to find another method of working the machine. After experimenting with horses, it was decided to employ the power of the water-wheel. In 1771 the three men set up a large factory next to the River Derwent in Cromford, Derbyshire. Arkwright's machine now became known as the Water-Frame.

Cromford Mill expanded through the early 19th century, but lost its edge as steam power became a cheaper and more reliable form of more intense power generation. It is currently in some serious disrepair, but the Arkwright Society has an ambitious restoration plan. Of course, it requires a lot of money. I hope they can appeal to modern entrepreneurs, with something along the lines of "you wouldn't be able to do what you do if it hadn't been for Arkwright, his vision, his business model, and the exceedingly productive and rich modern world that he helped to create".

The small exhibition they have set up also illustrates some important features that not enough people realize. First, Arkwright quickly had to advertise in regional newspapers to hire workers, because he quickly required more workers than the local economy could provide, even at the good wages he was offering. And that's the second point: they show some of the wagebooks from the time, and put them in the context of the real opportunities of the workers. Arkwright offered wages that competed with the wages offered to other local workers for such delightful and enjoyable professions as lead mining. Lead mining is one of the nastiest jobs of the 18th century working life (and of 19th, 20th, and 21st, as far as I'm concerned), so the next time someone starfts spouting about the exploitation of the industrial factory worker and how factories oppress laborers, remember that their alternatives were substantially less pleasant than we in our 21st century hindsight comfort can comprehend. Arkwright also required that children who would work in his factories go to school, as they were not allowed to work unless they could read and write and do sums.

I heartily recommend a visit to Derbyshire, for the scenery, the villages, and the rich industrial history that was so pivotal in unleashing the creativity that spawned our rich and diverse modern lives.

... but for some reason, this time it really stinks. I've even been staying up until almost 11, but I still wake up around 5, and usually I'm a 9-hour sleeper. This is the second day I've gotten up around 5, and I can already tell that today will be as brutal as yesterday was, probably more so because I have more meetings. Grrr.

I read the paper on the way to the airport, and this Wall Street Journal article from today (subscription required) provides a nice overview to the technological and commercial state of the broadband over electric business proposition.

As one of the quotes says, this certainly does put another spin on the "last mile" dynamic, at least for telecom. Beneficial disruptive innovation, anyone?

I'll be speaking on Friday at a conference in Austria, and I begin my travels this afternoon. So posting over the next week is likely to be light or nonexistent.

I hope to come back with a restaurant review from Artner, the restaurant where my colleague Geoff and I are having dinner Wednesday night.

TTFN!

Cinergy has announced that they are moving forward with plans to develop and commercialize broadband over power wire service:

Cinergy Corp., owner of several Midwest utilities, and privately held Current Communications Group on Tuesday said they have formed two joint ventures to provide high-speed Internet service over electric power lines. ...

Last week, the Federal Communications Commission proposed rules to foster growth in broadband over power lines, saying the service could increase the availability of broadband in rural and underserved areas due to the wide reach of the power grid.

Cinergy's press release provides more details. They will start with data transmission and move toward VOIP service.

On Friday I attended an important event in Chicago that shines an optimistic beacon into the stagnant state of electricity policy. The event was the announcement of the first year’s results of the Community Energy Cooperative’s residential demand response program. This program’s results are exciting, and should open our thoughts to a wider range of choices and business models when we think about selling electricity, even to the smallest customers.

Demonstrations that residential customers will respond to electricity price changes are thin on the ground. Common wisdom typically suggests that residential customers are very unresponsive to price changes, and that the price inelasticity of their electric demand would make any residential demand response minimal. In light of this common belief, and in this current state of regulatory limbo and risk aversion, the demonstration of residential demand response from Chicago in 2003 is particularly welcome and refreshing.

The Energy Smart Pricing Plan is a joint effort between the Center for Neighborhood Technology’s Community Energy Cooperative and Commonwealth Edison. In its first year, the program had over 750 participants in a variety of neighborhoods and types of homes, from large single-family homes to multiple-unit buildings. Commonwealth Edison provides the hourly prices, on a rate tariff approved by the Illinois Commerce Commission.

The keys to the Energy Smart Pricing Plan are simplicity and transparency in the transmission of information to residential customers. Participants receive a simple interval meter, and can either call a toll-free phone number or visit a website to see what the hourly prices will be on the following day. Furthermore, if the next day’s peak prices are going to exceed 10 cents/kilowatt hour, customers receive a notification by phone, email or fax. Customers will never pay a price above 50 cents/kilowatt hour, which the Community Energy Cooperative implemented by buying a financial hedge at 50 cents.

Friday’s event included a presentation of the independent evaluator’s report on the program. In the first year of the program, customers saved an average of 19.6 percent on their energy bills. They generally joined the program expecting to save $10/month on average, and were not disappointed. Surveys indicate that the participants found the price information timely, and that with this small inducement to save money on their energy bill by making small behavioral modifications, they actually became more aware of their energy use overall, not just in the approximately 30 hours last summer that had higher prices. They also said that their personal contributions toward reduced energy use and improving the environment by participating in this plan really mattered to them.

The most remarkable outcome is that even though it was a mild summer, participants did respond in the few hours that prices rose. Most responded by increasing the temperature on their air conditioners or shifting their laundry time to off-peak hours. The econometric analysis of the results showed a price elasticity of demand in those hours, at the margin, of –4.2 percent. In other words, when price rose by 100 percent, participants reduced their electricity use by 4.2 percent. For residential electricity customers, this is a healthy response, particularly given the lack of severe weather conditions. And that 4.2 percent reduction in use is a reduction at the margin, a margin that can often see prices go up by more than 100 percent in peak hours on hot days. So although the elasticity number may sound low, because it is at the margin and at the right time, it can take strain off of the system and contribute to grid stability and service reliability in those hours. And taking strain off of the grid at the margin in peak hours is crucial, as we saw last August in the Northeast blackout.

Customer response to price changes benefits not only those who respond, but also other customers and the system as a whole. Reducing peak use reduces wholesale market prices and long-run investment requirements that affect all customers, not only those who choose to see price changes. This widespread consequence of customers having the right to say “no” is the most powerful tool for public interest that comes out of demand response.

Utilities can also benefit from such demand response programs. The historic development and regulation of the industry has led to a culture in which the prevailing business model for a utility is “sell more power, make more profit.” In this world, utilities are prone to perceive the load reduction that can come from demand response as a direct assault on their profits. But what demand response shows us is that electricity can be sold as a differentiated product according to time, not just as homogeneous electrons. Furthermore, that differentiated product can be priced in ways that reflect the true cost of selling it in that hour.

In other words, demand response opens up the possibility that utilities can make more profit by selling less power. But they have to see it as a viable business proposition, and regulators have to show leadership in enabling utilities to offer their customers a portfolio of contracts from which to choose, even those that include choosing to pay higher prices some of the time.

Customer choice and demand response can also reduce the utility’s costs in the long run. Investment in generation and transmission assets is determined by the level of peak demand, and the more extensive programs like the Energy Smart Pricing Plan become across all types of customers, the longer is the timeframe between costly and unpopular investments. Unfortunately, in the current regulatory environment that is based solely on cost recovery and profit as a rate of return on assets, neither the utility nor the regulator has incentives to provide the means for saving on future investment.

Hopefully results from projects like the Energy Smart Pricing Plan will change these counterproductive incentives. Empowering customers to choose when and how they consume and pay for power is good public policy, good for getting the most out of costly investments, and good for the environment.