Economically Efficient Energy Choices

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If a person has the choice of installing oil, gas, or electric systems to heat a house and believes that any one of the three would perform equally well, the system that is cheapest is the efficient choice. If, however, the individual compares heating with an oil furnace to heating with a wood-burning stove, monetary cost may not be the only consideration.

Wood may be cheaper and oil more convenient. If two people are confronted by the same information and one chooses wood while the other chooses oil, both decisions may be economically efficient in the sense of maximizing the utility, or satisfaction, of the decisionmaker.

People differ in their preferences and in the value they put on their time. For consumer choices in particular, the entire list of qualities of services provided by different energy sources can be important. For example, both kerosene lamps and electric lights can be used to illuminate a home. Most households shifted quickly to electricity once it became available, and few would shift to kerosene today even if kerosene for lamp fuel were free. The lighting provided differs in more ways than cost.

Inputs and outputs usually can be valued according to market price. The opportunity cost of any choice is the best opportunity that has to be given up to make that choice. For the firm, the opportunity cost of oil or natural gas is measured by the price the firm must pay for it. That does not imply that the firm will always choose the cheapest fuel, because the costs of using the fuel must also be considered. Even in a situation where electricity is many times as expensive per British thermal unit (Btu) as coal, the firm may choose to buy electricity to operate lights, motors, and computers.


Energy can almost always be replaced in part by other inputs. For example, a steam pipe can be insulated more heavily or an industrial process can be modified to use more labor and less energy. Economic efficiency does not imply minimizing the use of energy or any other input, but rather finding the appropriate mix of inputs. The economically efficient level of inputs is reached when the last dollar spent on energy yields the same amount of benefits as the last dollar spent on labor or materials or any other input.

In discussions of economic efficiency, the concept of decreasing marginal rate of substitution plays a crucial role. This simply means that for a great many different activities, it becomes increasingly difficult to substitute one input for another as one continues to make substitutions. For example, a household with access to both electricity and natural gas probably will use gas for heating the house, electricity for lighting and refrigeration, and might choose to use either one for cooking, heating water, and drying clothes. It is possible to shift all of those activities to either energy source, although electric heat is expensive in most applications and gas refrigerators and lighting are rarely used when electricity is available. The substitutions become increasingly expensive as one moves to one extreme or the other. If the quality of the service offered by either fuel is identical, then the most efficient mix of energy sources would be the cheapest mix, which would depend on the relative prices of natural gas and electricity.

Firms face similar substitution possibilities in many of their activities and especially in industrial processes. Large commercial and industrial firms can even substitute electricity that they generate themselves for some or all of their purchased electricity. In the choice between purchasing and generating electricity, the two are perfect technical substitutes—that is, one can be substituted for the other without encountering a diminishing marginal rate of substitution. However, the cost of generation will increase as the firm tries to cover its own peak loads.

An investment in new equipment generally must be made before one energy source can be substituted for another. If new investment is required, the decision to switch fuels is not lightly made in response to fuel price fluctuations, particulary if they are viewed as temporary. In such cases, energy choices are most easily made when the activity is in the planning stage. For example, in some places new homes constructed in the late 1970s were not allowed to have connections to natural gas lines because the policy of the federal government was based on the assumption that gas reserves would soon be exhausted. New houses that were built with electric resistance heating systems required major investments before they could be converted to natural gas when the misguided policy was abandoned.


In comparing the economic performance of energy alternatives, it is essential to take account of the times at which costs are incurred and benefits received. For example, in the case of a railroad line that crosses a range of mountains, it is possible to save fuel on every trip by tunneling under the mountains instead of traveling over them. Does this mean that the mountain crossings should be replaced by a tunnel? Suppose that the tunnel is on a lightly traveled route, costs $1 billion to construct, and will last indefinitely. If it saves $1 million per year in fuel and other operating costs on an ongoing basis, is the project economically efficient? Ignoring the opportunity cost of capital, the sum of the annual savings would eventually (after one thousand years) equal the cost of construction. But the resources devoted to its construction have an opportunity cost and the project is not cost-effective when the opportunity cost is taken into account.

Discounting makes it possible to compare costs incurred at one time with costs and benefits received at another taking into account the opportunity cost of capital. In the absence of such a procedure, one cannot compare alternatives that differ in the timing of their costs and benefits.

A dollar that will be received a year from today has a "present value" of $1 divided by (1+r), where r is the discount rate, which is equal to the opportunity cost of capital; and a dollar that will be received two years from today has a present value of $1 divided by (1+r)(1+r) or (1+r)2. A payment that is to be received t years from today must be divided by (1+r)t. If the opportunity cost of capital is fairly high, savings that will be realized many years from today will be heavily discounted. For example, if r is 10 percent, the present value of a dollar that will be received seven years from today is about 51 cents. If a dollar will be received twenty-five years from today, its present value is not even a dime. The total value of the tunnel that saves $1 million per year indefinitely is only $1 million divided by r. If the opportunity cost of capital is 10 percent, the tunnel is worth only $10 million. The economy will not prosper if it sinks $1 billion in building a tunnel that will generate only $10 million of benefits.

While this example is constructed to be an extreme case, it illustrates the importance of not being misled that a long-lasting stream of returns necessarily means that a capital investment will be profitable. Returns from energy savings to be received far in the future will have a low present value unless some mechanism works persistently to raise future energy prices at a rate that is commensurate with, or exceeds, the discount rate.

After the average crude oil price increased from $3.18 per barrel in 1970 to $21.59 in 1980, many analysts forecast skyrocketing energy prices for the remainder of the century. The "middle price path" of the U.S. Energy Information Administration in 1979 projected a nominal price of $117.50 per barrel in 1995! Such forecasts seemed to be soundly based not only in recent experience but also in the economic theory of exhaustible resources. As a consequence, U.S. industries invested heavily in energy conservation measures, with the result that industrial consumption of energy decreased from 31.5 quads in 1973 to 27.2 in 1985. Some of this investment was probably not warranted on economic efficiency grounds because prices ceased to rise after 1981, and even plummeted to $10 per barrel in 1986.

Whether the most energy-efficient equipment is also the most economically efficient depends on the circumstances. For example, a truck operator may be able to cut the fuel costs in half by spending $100,000 to replace an old truck with a new, energy-efficient model. But if a long-haul trucker spends $30,000 per year on fuel, the half saved is a significant amount. But if the truck is used mainly to shuttle containers between a port and nearby warehouses, the annual fuel bill might be $5,000 and the half saved ($2,500 per year) not enough to justify spending $100,000 for the new truck.

Similarly, an electric motor can use electricity that costs more than the motor during a year of continuous operation. Even if the motor is in perfect condition, it may be cost effective to replace it with a new motor that is a few percentage points more efficient at converting electricity into work. In many applications, however, an electric motor operates only a few hours per year. In such cases, the cost of the electricity is negligible relative to the cost of a new motor, so that even a large gain in energy efficiency is not worth the cost.


As can be seen from the above examples, one characteristic of the concept of economic efficiency is that it takes account of all inputs, not just energy. Even if one were interested only in conserving energy, the economic approach would guide one to use labor, capital, and other inputs to conserve the greatest possible amount of energy for the budget. Of course, the economic approach is not usually associated with minimization of any one input or maximization of any one output, but rather with the minimization of costs for a given level of benefit or maximization of net benefits.


Because economic efficiency is simply a description of the rules by which individuals and firms can gain the most of what they want, another characteristic of economic efficiency is that firms and individuals do not need orders or special incentives to induce them to pursue it. They are simply acting in their own interest as they see it.

All of the information required for firms and individuals to pursue economic efficiency is conveyed by the price system. The price of natural gas relative to coal conveys information to all potential users of the two fuels about their relative scarcity. The price of the output relative to the inputs conveys information to potential producers about whether an activity will be profitable to expand. Decisionmakers can then pursue activities to the point where the benefit of expanding any activity or of any input in any activity is equal to the cost of that expansion. The price system is especially valuable because it conveys subtle information that is otherwise very difficult to ascertain or to factor into the analysis. Attempts to allocate particular inputs by rules or bureaucratic orders in wartime or in other controlled economies have invariably proved extremely inefficient, at best, and often disastrous.


This powerful effect of prices in conveying information throughout the economic system naturally leads to the question of whether the information conveyed about inputs and outputs generally, and about energy specifically, is accurate. Critics have indicated various ways in which energy prices can be misleading. One classic problem is that of external costs. For example, unregulated coal mining pollutes streams with acid drainage from underground mines and silt from unreclaimed surface mines. In such a world, the market price of coal, to which firms and individuals react in making their decisions, is too low because it does not include such damages. One possible solution to this problem is to assign ownership of the stream to someone (anyone), who would then charge polluters for the damage done. The cost and market price of coal would then incorporate the formerly external costs.

Generally, the United States has not followed this approach. Instead, regulations have been promulgated to specify either the production techniques that must be used to eliminate or lessen the external costs, or the permissible levels of emissions of pollutants. These regulations have helped to clean the environment and also have increased the cost of energy, but few economists would claim that the existing set of regulations leads to the same behavior and the same efficiency that a perfected set of prices would. One particular difficulty is that regulations rapidly become obsolete as technology and markets change, whereas prices adjust to changed circumstances and exert pressure for behavior to adjust accordingly.

Another characteristic of the economic-efficiency concept is that it does not require arbitrary decisions by the analyst about, for example, how coal should be evaluated compared with natural gas. The question of whether 1 Btu of coal is equal to 1, or perhaps 1/2, Btu of natural gas is answered directly by the market. The weightings of the marketplace, revealed in relative prices, vary with scarcity, cost of production, technology, and human preferences. Decisionmakers do not need to think about the underlying reasons, however. They need to know only current prices (and make their best guesses about future prices).

Prices can fail to reflect true social cost for reasons other than externalities. Factors such as taxes, subsidies, monopolies, and fear of expropriation also can cause prices to diverge from marginal social cost.


The characteristics of economic efficiency noted above are considered advantages by most economists and disadvantages by a small group of critics, many with an ecological orientation. The most politically influential challenge to the concept of economic efficiency comes from "net energy analysis" (NEA). This type of analysis attempts to convert all inputs and outputs into weighted energy equivalents in the hope that the resulting project appraisals will be more stable and consistent than those provided by economic analysis. Arriving at weights for different forms of energy and energy equivalents for labor and capital has proved to be difficult and controversial. Moreover, some analysts question what use can be made of the results of NEA if they differ from those of economic analysis.


Within the mainstream of economics, no serious challenges to the conventional analysis of economic efficiency have been sustained. Judgments differ on the extent to which market prices may need to be adjusted to compensate for externalities or other imperfections. For example, does global warming (presumed to result from emission of carbon dioxide and other greenhouse gases) pose a serious enough threat that the prices of all fuels containing carbon should be raised by imposing a tax equal to the amount of the damage done? If so, how much is that amount? Note that the disagreements about this issue reflect real gaps in knowledge about the effects of carbon dioxide emissions, not disagreement about the concepts and analysis.

Similarly, economists generally agree that analyses involving time require discounting according to the standard formulas, but disagree regarding which discount rate should be used. The basic issue is that using a high discount rate is equivalent to saying that benefits or costs that are expected far in the future do not receive much weight in decisions made today. Why worry about the costs of global warming if they will not be felt for a century or more? At any reasonable discount rate, the value of a dollar received a century from today is negligible. Some critics have argued that we owe something to future generations and therefore should value their preferences as highly as our own.

The supply of capital is limited, however. If an investment that yields a 2 percent return is adopted because it yields benefits to future generations, but if it consumes capital that could have yielded a 20 percent rate of return to an investor, the capital stock will grow more slowly. To maximize growth of physical capital and personal income, the highest-yielding investments should be chosen.

William S. Peirce

See also:Economic Externalities; Efficiency of Energy Use; Efficiency of Energy Use, Economic Concerns and; Efficiency of Energy Use, Labeling of; Energy Economics; Environmental Economics; Green Energy; Industry and Business, Energy as a Factor of Production in; Industry and Business, Productivity and Energy Efficiency in; Risk Assessment and Management; Subsidies and Energy Costs; Supply and Demand and Energy Prices; Taxation of Energy; True Energy Costs; Utility Planning.


Gilliland, M. W. (1975). "Energy Analysis and Public Policy." Science 189:1051–1056.

Hayek, F. A. (1945). "The Use of Knowledge in Society." American Economic Review 35:519–530.

Huettner, D. A. (1976). "Net Energy Analysis: An Economic Assessment." Science 192:101–104.

Mikesell, R. F. (1977). The Rate of Discount for Evaluating Public Projects. AEI Studies 184. Washington, DC: American Enterprise Institute for Public Policy Research.

Peirce, W. S. (1996). Economics of the Energy Industries. Westport, CT: Praeger.

Pindyck, R. S., and Rubinfeld, D. L. (1998). Microeconomics, 4th ed. Upper Saddle River, NJ: Prentice-Hall.

U.S. Department of Energy, Energy Information Administration (1979). Annual Report to Congress. Washington, DC: U.S. Government Printing Office.

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Economically Efficient Energy Choices

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