What

1
Whats 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

2
Roadmap

• The outcome of a well functioning market
• Thinking like an economist
• The different market failures in
  transportation/energy markets
• How to fix them
• Arguments against these fixes
• Alternatives
• Economics culture please interrupt with
  questions or comments

3
The first best

• 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 dont like the distribution of the slices,
  we address that through policies that dont
  affect the size of the pie
• These are transfers that dont affect the actions
  of agents (more on this)

4
Market failures

• If the market does not lead to a Pareto efficient
  outcome, we say it fails
• It is the existence of market failures that opens
  the door for policymakers (and, thus governments)
• Transportation markets have many failures
• My plan is to discuss the main ones
• Notice that this is powerful If you cant point
  to a market failure, then the market will
  maximize the size of the pie
• Government intervention can only reduce the size
  (weakly)

5
Some principles of economics

• People/society face tradeoffs
• People respond to incentives
• These seem obvious
• 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 doesnt
  guarantee everyone gets a larger slice
• The cost of something is what you give up to get
  it
• Opportunity costs matter, not accounting costs

7
Some observations

• The first best depends on the current system
• 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 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 hasnt been
  built, so these high capital costs are not sunk
  and should be considered
• The optimal system can vary by country

8

• If a consumer faces the true social cost of
  something and chooses to purchase it, then this
  is good for society
• If you dont 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!

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Analyzing market failures

• The ultimate goal is to understand how market
  failures affect efficiency and to design policies
  that correct these failures
• Market failures come down to consumers/firms not
  facing the correct marginal incentives
• Either prices or benefits are too high/low

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Major market failures present

• Externalities
• Failure of agents to face correct
  costs/benefits
• Network Effects/Coordination problems and
  investment spillovers
• Failure of agents to face correct benefits
• Market power
• Firms pricing above their marginal cost
  (incorrect MB)
• Asymmetric Information
• Can lead to missing markets

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The pillars of economics
marginal social cost
S
P
First, the ideal
P
marginal social benefit
D
Q
Q
12
Negative externalities
marginal social cost
P
marginal private cost
S
DWL
P
PNE
marginal social benefit
D
Q
Q
QNE
13
Negative externalities in transportation

• 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

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Most frustrating part of being an economist

• Solving the negative externality problem is
  simple
• Place a tax on the item equal to the negative
  externality
• So-called Pigouvian Tax
• Advantages
• Direct,
• Generates revenues,
• Doesnt require knowing Q

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Negative externalities
Private cost tax
P
S
marginal private cost
t
P
PNE
marginal social benefit
D
Q
Q
QNE
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Arguments against taxes

• Political infeasible
• 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
• They might be politically infeasible because we
  stopped doing this!
• We should continue to calculate the social cost
  of this infeasibility
• Major problem were battling against oil and
  auto companies
• Shameless cite warning See, Fowlie, Knittel and
  Wolfram (2006)
• Harms the poor disproportionately
• Research suggests gas taxes are progressive up to
  the first 3 deciles, regressive from 4-10
• Remember, a tax generates revenue that can be
  distributed!!!
• Proposition 87 was almost perfect

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Arguments against taxes (cont)

• Transportation demand is too inelastic for taxes
  to work
• Shameless cite warning See, Hughes Knittel and
  Sperling (En. Jo. fthcmg)
• Notice, this just suggests that Q and QNE are
  close to each other
• Suggests we should look elsewhere for carbon
  decreases, whether we like it or not
• Price inelasticity and carbon inelasticity are
  not equal
• Suppose there was an alternative fuel that had
  25 less carbon, but always costs 10 cents more
  than gasoline
• With no carbon tax, this fuel would never be sold
• 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

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Arguments against taxes (cont)

• Inelastic comment continued
• Long Run elasticities difficult to measure
• Not a perfect experiment, but there are major
  differences between US and Europe
• 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

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Arguments against taxes (cont)
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Arguments against taxes (cont)
Private cost tax
P
S
marginal private cost
P
t
PNE
D
Q
QNE
Q
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Arguments against taxes (cont)

• Requires knowing the damages
• Yes. And these can be difficult to measure
• What is the value of a polar bear?
• But, any other policy instrument that I am aware
  of also requires this
• And usually more
• Lots 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)

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A nice alternative

• An alternative to a tax is a cap and trade system
• 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
• Very common in pollution market
• The basis for Europes Kyoto compliance strategy,
  Northeastern NOx market for powerplants, CAs
  RECLAIM market for NOx, Australia carbon market,
  etc.

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Cap and trade

• Why so common?
• Not a tax
• Permits are typically allocated in political way
• This lessons the effect on firms and some firms
  can even profit
• 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

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Cap and trade and S and D
P
marginal private cost
PCAP
PNE
Permit Price
marginal social benefit
D
Q
QNE
QCAP
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Arguments against cap and trade

• Positive demand shocks can lead extreme prices
• Australias solution -- cap the permit price at
  some level
• In fact, you could cap it at the level of the
  externality!
• Were back to the tax solution
• Effectively, this allows for an infinite number
  of permits at that price
• Transportation demand is inelastic
• See above.
• Cant have a cap on each driver
• 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

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Alternatives

• Pollution technology forcing (standards)
• National defense CAFE standards, LCFS, subsidies
  (negative taxes)
• Climate Changes LCFS, subsidies
• Congestion HOV lanes

27
New development in CA

• LCFS exciting new development
• Firms face a carbon intensity rate constraint
• Holland, Knittel and Hughes (2007) work through
  the incentives of the firms
• 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
• Used as to solve other market failures?

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(Indirect) network effects

• So-called chicken and egg problem
• E.g., hydrogen automakers need hydrogen refueling
  stations, hydrogen refueling stations need
  hydrogen automobiles
• Exists in many industries any hardware/software
  industry
• 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)

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marginal social cost
S
P
P
marginal social benefit
marginal private benefit
D
Q
Q
QNet
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What do we learn?

• Network effects can lead us to get stuck at a
  non-optimal equilibrium (Windows?)
• We can also switch to a non-optimal equilibrium
• Largely depends on consumers expectations
• How do we solve them?
• They occur because each side of the market
  doesnt 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

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Market power the good market failure?

• In almost every other industry, the market
  failure we worry about most is market power
• Market power occurs when a firms 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
• Market power drives a wedge between price the
  social marginal cost the supply curve is no
  longer the MC curve
• So, we have deadweight loss from under
  consumption

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Sources of market power in transportation

• OPEC/Extraction
• 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
• For example, if P60, MPC10, Negative
  Externality50

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Can they cancel? Just for fun
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Where do we go from here?

• Unfortunately, the easiest and most direct way to
  solve many of the problems inherent in energy
  markets may not be politically feasible
• But, we shouldnt stop trying
• Most of the alternatives create perverse
  incentives somewhere
• (If not, they would be the preferred choice)
• These perverse effects require additional
  policies, which
• We cant lose trust in markets
• Energy markets are failing, for the most part,
  because the prices are wrong
• We cant use arguments like theyve never worked
  in the past, so they wont work in the future