The Concise Encyclopedia of Economics


by Robert A. Leone
About the Author
Energy is not a single industry, but many industries tied into every facet of our economy, from transportation and manufacturing to home heating and lighting. As chart 1 shows, in 1990 over 40 percent of U.S. energy consumed was petroleum. Natural gas was about 23 percent of the energy mix and coal about 22 percent. Nuclear accounted for about 7 percent, and other sources ranging from hydroelectric to solar power to geothermal geysers accounted for the remaining 8 percent.
Energy Use in the United States--1990
Chart 1. Energy Use in the United States—1990
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In most ways, energy is like any other economic commodity: when the price goes up, the quantity of energy used goes down. In some ways, though, energy is different, and energy markets do not reflect the true costs to society of energy use due to these differences. For example, the free-market price of energy does not adequately account for the burden on society of global warming or of urban air pollution. Some economists advocate a "carbon tax" so that those who use energy take account of their contribution to global warming. Urban air pollution from automobiles not only raises health care costs but affects our quality of life as well. Acid rain associated with electricity generation is estimated to cause more than $7 billion in materials corrosion damage annually throughout the seventeen eastern states in the United States. Economists point out, though, that a straight tax on energy is an inefficient way of dealing with pollution. A more efficient way is to tax the pollution directly. If governments taxed pollution rather than energy use per se, people would have incentives to produce and use energy in less-polluting ways.

Because of the environmental consequences of energy use and production, discussions of energy economics often are more emotional than rational. Such discussions are dominated by concerns about energy depletion and the limits to economic growth, the belief of many in the need for regulation of energy markets, and the exaggeration or misstatement of the political hurdles that must be overcome to address the real challenges of energy use in a global economy.

More dispassionate analyses give a different view of energy economics. There is little reason to believe, for example, that energy is a limiting factor in economic growth. Government statistics report that the United States has petroleum reserves that will provide the nation with oil for the next twenty-five years. It is a mistake to conclude from this, however, that in the twenty-sixth year there will be no gasoline. As old energy reserves are used up, new ones are discovered. In 1969, for example, total estimated U.S. oil reserves were about 30 billion barrels. More than twenty years later, after we had consumed 50 billion barrels of domestic oil, there were still almost 27 billion barrels of U.S. proved petroleum reserves.

Because industrial economies are so energy intensive, many people fear that limited energy supplies will limit economic growth. Again, the facts suggest otherwise. In 1960 the U.S. economy used over 26,000 BTUs of energy to produce each dollar of GNP. By 1988, due to technological improvements and increased energy conservation, the United States required only 20,000 BTUs of energy to produce the same real dollar of GNP. This 24 percent reduction in the energy intensity of the U.S. economy illustrates an economic truth called the law of demand: at a higher price, less of a good is used.

Another economic truth, however, is that higher income leads to higher demand for energy. While higher prices induced consumers to use less energy, higher incomes encouraged them to use more. The net result is that total energy use in the United States is still rising despite aggressive conservation efforts. From 1975 to 1990, GNP in the United States grew by 40 percent, while annual energy consumption rose 15 percent.

Some analysts take little solace in the U.S. statistics, citing the recent decline in domestic energy prices. From 1988 to 1990, the composite price of the three major energy fuels—crude oil, natural gas, and coal—was lower, in real dollars, than at any other time since 1975. These lower prices reduced the economic incentive to conserve energy.

Pessimistic analysts also cite the pent-up demand for energy in poor countries of the Third World. It is true that less developed nations will need to consume more energy as they industrialize. But there are grounds for optimism as well. There is much room left for well-developed countries to cut energy use. The world's largest energy user—the United States—still consumes twice as much energy per dollar of GNP as Japan or Germany. And even nations that today use much less energy per unit of output will be able to do still better as technology improves.

Aggregate statistics clearly show that energy use falls as the price rises. In spite of this evidence, many advocates of energy regulation still believe that energy consumers are insensitive to its price. This mistaken belief is reflected in the kinds of policies they advocate.

Consider gasoline consumption, one of the most emotional and visible issues. Those who believe that consumers do not adjust to changes in energy prices usually favor corporate average fuel economy (CAFE) regulations requiring that new cars meet prescribed fuel economy standards. Advocates of CAFE believe that cars get more miles per gallon because the CAFE laws were enacted in the midseventies. Advocates of a market-oriented energy policy believe that a major part of the increase in miles per gallon was due to gasoline prices that were much higher in the late seventies and early eighties than in the late sixties and early seventies. While there is likely some truth to the arguments of both groups, economic research indicates that the benefits of a market-driven approach to energy policy tend to be underestimated and the benefits of regulation exaggerated.

A case in point is a congressional proposal to require auto companies to make cars that get, on average, 40 miles per gallon (mpg), up from the current mandated average of 27.5. Absent an economic view, one might conclude that a fleet of vehicles averaging 40 mpg would consume one-third less gasoline than a fleet averaging 27.5 mpg. An economic view yields a different conclusion.

If gasoline is priced at $1.20 per gallon, gasoline costs 4.4;ct per mile in a vehicle averaging 27.5 mpg. This cost falls to 3;ct if the vehicle averages 40. In other words, the proposed regulatory initiative lowers the cost to drive a mile and, therefore, induces drivers to drive more miles. Empirical evidence shows that reducing the cost of driving a mile will encourage consumers to drive a little faster, purchase more pickup trucks instead of more fuel-economic passenger cars, and even drive cars slightly larger than they would have otherwise.

In addition, some consumers will be frustrated by less powerful and less safe 40-mpg vehicles and will keep their old cars longer, thus lengthening the amount of time it will take for the entire automobile fleet of used as well as new cars to achieve the 40-mpg average. All these economic responses by consumers reduce the energy savings anticipated by the proposed regulation. While each effect is small by itself, in the aggregate these consumer responses can offset perhaps half the anticipated savings from a 40-mpg regulatory requirement.

In contrast, a tax on gasoline would immediately affect the driving decisions of all drivers. The higher price would discourage driving additional miles, not encourage it. The higher price would also hasten, rather than stall, decisions to buy new vehicles that get better gasoline mileage. And a higher price would encourage consumers to drive fuel-economical passenger vehicles instead of trucks and utility vehicles. By one estimate, when all these factors are brought together, the United States could save as much gasoline over a ten-year period with a five-cent-a-gallon gasoline tax as it would by raising the CAFE mileage requirement from 27.5 mpg to 40 mpg.

The equivalent gasoline tax is so low, not because the consumer response to a nickel tax increase would be so large, but because the impact of the 40-mpg regulatory standard would be so small. The impact of regulation is so small because consumers adapt to even the best-conceived regulatory initiative in creative and unanticipated ways. That is simultaneously the virtue of energy markets and the reason why energy policy initiatives often accomplish less than their advocates intend.

Political debates over energy policy are inherently controversial because the stakes are so large and because the effects of policy changes fall unevenly across society. There may well be excessive controversy, however, because conventional views of the consequences of higher energy prices are not entirely accurate.

Many people believe, for example, that higher energy prices are especially harmful to people with low incomes. It is certainly true that low-income families spend a higher percentage of their income on gasoline than high-income families do. But that is not the end of the story. Low-income families are more likely to purchase used cars than new cars. Purchase prices for used, gas-guzzling cars fall as gasoline prices rise. So part of what low-income families pay in higher gasoline prices, they save by paying a lower price for their cars. Also, higher-income families engage in many more energy-intensive forms of consumption and recreation, such as boating, air travel, heating and cooling larger homes, and so on. When all these factors are combined, it is far less obvious that the poor spend proportionately more of their income on energy from all sources.

Moreover, if higher energy prices are caused by taxes on energy, the tax revenues generated would go to governments in the United States. Because these governments provide services consumed disproportionately by lower-income families (and assuming that the governments provide these services efficiently—a big assumption), the net effect of higher energy prices would be an increase in the real income of low-income families.

Because energy is so basic an economic commodity and because we produce it and consume it in so many different ways, even the most innovative regulator cannot anticipate all the ways that consumers will adapt to a changing energy market. A sound economy also requires full use of the creativity and responsiveness that markets can provide to changing energy realities.

About the Author

Robert A. Leone is a professor of operations management at the Boston University School of Management. He was an energy economist with President Carter's Council of Economic Advisers.

Further Reading

Bohi, Douglas. Energy Price Shocks and Macroeconomic Performance. 1989.

Kaplan, Seymour. Energy Economics: Quantitative Methods for Energy and Environmental Decisions. 1983.

Ross, Marc. Our Energy: Regaining Control. 1981.

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