U.S. Energy policy and the presumption of market failure.

AuthorGrossman, Peter Z.
PositionReport

Over the last 35 years, the U.S. government has embarked on several major projects to spur the commercial development of energy technologies intended to substitute for conventional energy resources, especially fossil fuels. Those efforts began with the 1973 energy crisis when President Nixon became the first U.S. leader to announce a plan for energy autarky. Presidents Ford and Carter followed Nixon's "Project Independence" with similar pledges. But beginning with Ford's 1975 energy act, plans for energy independence were tied directly to the development of new, alternative energy technologies. Under President Carter in particular, the federal government embarked on highly publicized, heavily funded efforts at developing new technologies with specific timetables for commercial entry and, in a few cases, a timetable for mass market substitution. Current mandates for ethanol and other biofuels fit this latter objective.

The presumption underlying government alternative energy programs, including the ethanol program, is that voluntary market action is insufficient to develop new energy sources. Therefore, government has to step in to induce the technological development the market fails to create. Only through government intervention, according to this logic, can the market failure be corrected and the social benefits of alternative energy technologies be realized (Weimar and Vining 1992).

Whether a market failure has or has not existed with respect to alternative energy technologies, it is nonetheless relevant to ask whether the government's action creates a solution or a failure of its own. The importance of government failure has been highlighted in recent years as government efforts in such diverse areas as inland waterway development, antitrust law, and public transportation appear to produce far more costs than benefits, and sometimes may worsen whatever market failures they were intended to correct (Winston 2006). (1) The evidence suggests that with respect to alternative energy development, government failure has in fact been a more persistent and costly problem than market failure.

This article will argue that government energy policy has been based on faulty premises not only about the existence of market failure but also about the nature and process of innovation. Moreover, as this article will show, there is evidence that the private sector can develop energy alternatives more efficiently than the government.

The article is organized as follows: first, I discuss the basic idea of market failure and how it has influenced U.S. energy policy. I also suggest that governmental solutions would have been unlikely to succeed even if a market failure had been correctly identified. Next, I focus on three efforts at government-directed innovation: synfuels, nuclear fusion electric generation, and the high-mileage automobile. All three were given significant funding and programmatic timetables with benchmarks of success. None of those timetables were met, few of the benchmarks were achieved, and development funds were largely wasted. Finally, I end with a discussion of how the federal government continues to pursue the same kinds of policies that offer the promise of more failure.

The Market for Innovation: Market Failure or Government Failure?

Ronald Coase (1964) argued that all forms of economic organization--markets, firms, and government--are "more or less failures." That is, no real-world arrangement of economic institutions leads to ideal allocative or productive efficiency of the sort represented in the neoclassical model of perfect competition, which by definition allocates resources through markets so that there are no alternative arrangements that would lead to a higher level of social welfare. But since that model is based on unrealistic assumptions, Coase argued, it had to be assumed that all real-world markets fail to some extent, a point elaborated by Demsetz (1969). Of course, firms and government command systems dearly fail as well, and substituting command for markets does not guarantee success. The goal, Coase suggested, is to organize any particular type of economic activity using the form of organization that fails the least in a given situation. (2) Of course, one cannot know with certainty that one form of organization will fail less than another in a particular circumstance, although experience should provide some guidance. With respect to government energy development programs, there is 35 years of experience to draw on, but this history seems to be entirely ignored by decisionmakers in proposing new programs.

How is it that the alternative energy market is presumed to fail? A new energy technology could potentially be worth billions of dollars, but an entrepreneur must bear a considerable development expense while his reward is uncertain. Of course, the greatest uncertainty is simply: Will the technology be marketable? But even if it is, the entrepreneur may be unable to keep others from cashing in on his efforts with competing products, and certainly he cannot gain some benefits that are attained by society as a whole. For example, a new technology might reduce the need for defense spending to protect oil supplies, but that benefit while dearly substantial--cannot be captured by the entrepreneur who created the technology. The problem of uncertain or unattainable benefits but fully internalized development costs means that entrepreneurs will be reluctant to invest in innovative energy technologies, which will consequently be undersupplied if left to the market alone (Arrow 1962).

But even if this premise is accepted, it is not immediately clear what government can or should do to correct it. That is, with respect to energy policy, what can government do that will lead to a successful new energy technology and not produce an even larger government failure? Policymakers have tried numerous schemes, some as low-cost and low-profile as simple information gathering. However, the most costly and the most visible by far have been efforts to induce innovation. Typically, policymakers have relied either on programs that provide incentives (usually tax preferences) to adopt a new technology or that undertake technology development directly.

Neither of those types of programs has been successful, but the second, direct development, is especially problematic in principle as well as practice. Government programs to create commercially viable alternative technologies of any kind rest on three implicit assumptions--all of them, at best, dubious.

First, and perhaps most important, is that government must assume that innovation is a demand-side phenomenon. U.S. energy policymakers appear to believe that since consumers want alternative energy technologies, someone should have built and marketed them. Since no one has, the assumption is that the market is failing to provide the incentives for innovators to act.

But the concept of demand-led innovation has very little empirical support. In the 1960s, a few scholars--notably Jacob Schmookler (1966)--attempted to link the technological developments of the Industrial Revolution to a surge in demand. This theory seemed especially inviting at the time because it echoed the Keynesian demand-side perspective that dominated macroeconomic theory.

But the demand-side explanation has not survived careful analysis. Today, nearly all scholars agree that innovation is a supply-side phenomenon (Mokyr 1977). As Nathan Rosenberg (1976), a leading economic historian of technology, has argued, scientific knowledge evolves if not randomly at least unevenly and its employment in marketable developments is certainly unpredictable and not necessarily consistent with consumers' desires at a given point in time. The complexity of science makes it hard to foresee, much less to program, what kinds of new ideas can generate what kinds of new products. Only after technological developments occur, will entrepreneurs evaluate opportunities for commercial development, and the verdict on whether they are right or wrong will be rendered in the marketplace. Though supply-side theories of innovation have had much more success in explaining technological development, government alternative energy programs directed at correcting the market's failure to supply innovative products take for granted a demand-side explanation to the innovation process.

Some experts argue that government can compel firms to innovate through the use of both incentives and disincentives. In the literature, this concept is sometimes referred to as "technology forcing." The catalytic converter in ears is the example most frequently noted (Gerard and Lave 2003). Government commanded a reduction in automobile pollution and the converter resulted (albeit a few years later than mandated). But the converter was not intended to compete with an existing conventional technology as alternative energy technologies are expected to do. In fact, there is simply no example of government "forcing" a commercially viable alternative energy product.

The second assumption is that if a technology has been demonstrated to be possible, government support will be needed to make it commercially viable. Exactly what this is based on is unclear. Government support is not by its nature designed to produce competitive market results. Instead, as Public Choice theory explains, government intervention creates competition among entrepreneurs primarily to gain government support. In the very nature of the funding process, money for development will often go to the entrepreneur that (a) is most likely to meet political goals of legislators, and (b) does the best job of convincing government officials of the superiority of his approach. Once support has been obtained, the entrepreneur has no need to work toward market competition and, in fact, has a great motivation to prevent market competition from arising. Overall, this situation...

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