This is Part II of what I anticipate will be a 3 part post. In Part I, I tried to set up the intractable dilemma that has prevented the net oil consuming nations such as the U.S. from formulating a rational energy policy that the majority of people can readily support.
On the one hand, the international oil markets are not open and competitive in that the majority of producing oil reserves are in the hands of countries which view it not as an open economic commodity but as a strategic asset with political ramifications. As such, the historically high and escalating prices that are constraining economies worldwide cannot be simply relegated to the inevitable consequences of supply and demand and market economics and the limited control of these strategic assets poses a risk to the stability of the global economy.
On the other hand, current alternative energy technologies such as solar and wind are not yet financially viable and therefor economically rational substitutes for oil as an energy source, particularly if one honestly assesses the social costs associated with their large scale implementation. Their position as viable economic substitutes is further diminished by the unpredictability of oil prices which are not reflective of a competitive market such that a near-term price reversal could be engineered to undermine at great cost whatever investment were spurred in alternative technologies by the current high price levels.
The Basis of Economic Value -- Why We Want What We Want and Why We're Willing to Pay What We Pay
As a foundation for finding a way through this dilemma, I think we need to consider what drives certain people to want one thing and others to want something else, how diverse goods wind up priced relative to one another, and how we decide what we're willing to pay for both seemingly similar and seemingly different products. Or to put it differently, how a value proposition relates to the economic value we see in a certain good or service.
The value inherent in a good as reflected in its price has been a key question for economists since there became such a thing as an economist. Early on, economists postulated that the value of a good should correlate to the extent that the good is needed by consumers. This quickly gave rise to the classic paradox of diamonds and water -- other than some very specialized industrial cutting applications, diamonds are hardly needed at all, and yet they have always been priced far higher compared to water which we can't live without and yet is virtually free.
From this line of thinking quickly came the idea that prices are determined by scarcity -- the harder a good is to come by, the higher the price it can command. While scarcity is certainly a driver of prices, it can only impact the prices of things for which there is a corresponding demand -- people must want it for some reason -- must attach some value to it -- or it doesn't really matter whether its scarce or not existent at all. And the issue of scarcity itself can be more complex than it might seem at first blush. Applying the question to alternative energy, there is no scarcity of sun and wind in many parts of the globe, but the high cost of converting these resources to energy is not a function of the availability of the underlying resource itself.
Some understanding of how we place value on things can be gained by comparing buyers of different automobiles. Take for example a Toyota Prius, a Porsche 911, and a Hummer. At the root they are all means of transportation, and similar means of transportation at that -- four rubber tires driving along the identical asphalt roadways powered principally by internal combustion engines. Further, they are all sold to consumers through pretty much the same distribution channels -- independent dealers relying primarily on direct sales through show rooms.
But I don't think anyone would seriously believe that a person buying one of these three cars is buying the same thing as someone buying one of the others. Indeed, I'm not sure a person buying a Prius could even have a civil conversation with a person buying a Hummer. The importance of the emotional value we associate with the things we purchase and how the alignment of our world views with a product's value proposition affects our desire to make a particular purchase and how much we're willing to pay for a particular good is well presented in the works of a number of modern marketing gurus, my favorite of which is Seth Godin (author of such must read books as "All Marketers Are Liars" and "small is the new big").
The buyers of a Prius might say that they are trying to save money on gas, but most studies I've seen make it pretty clear that it takes a few years to save enough gas to make up for the higher price of the hybrid engine in the first place. The truth is, the owner of a Prius is willing to pay a little more for the car than can be saved in gas because at a deep emotional level they want to be doing something to help save the planet. It's not a car as much as a statement about environmental consciousness. The buyer of a Hummer, on the other hand, doesn't need to save the planet -- he owns the planet. He rules it whether it's paved or not. Meanwhile, the Porsche buyer is seeking to be one with the world -- at least that part of the world covered with long stretches of smooth asphalt and well engineered curves. Zen meditation would probably be a cheaper route to "oneness", but for this person "oneness" isn't about the price tag, but about speed and handling.
The point here is that people want these things and are willing to pay certain prices for them not because they need the particular functionality or because of their relative scarcity or availability, but because of a deeper emotional value associated with what the product says about them as people.
Another modern illustration of this is how people are willing to pay considerably more for a cup of coffee at Starbucks when they could get a very similar cup of coffee elsewhere for much less. Let's face it -- when it comes to Starbucks, the higher price is certainly not because they're scarce. Starbucks would be the first to say that coffee isn't even their core product. They sell a community and a sense of cultural identity that sparks a gratifying emotional response from their loyal customers. Serving coffee just happens to be one part of creating that emotional response.
We can come full circle on this by updating the paradox of the economic value of water -- only instead of water and diamonds, we can compare water and bottled water. In most places in the developed world, clean drinking water is free. And yet millions of people pay quite a bit of money for bottled water. Indeed, when translated from the average 16 ounce to 24 ounce bottle to a gallon, the price of this water can be well over $10 per gallon -- and we willingly pay this price when in most cases we could get a cold drink of water for free. And yet we blanch at $4 per gallon gasoline. Talk about a paradox.
Some of this water comes from as far away as Fiji, and some is bottled from the municipal water supply. The price isn't driven by the cost of the container or the cost of transporting the water from the well head to our refrigerator. And it certainly isn't driven by the scarcity of the product or unique control over the essential natural resource or the value of some proprietary technology for finding and bottling water. Bottled water readily commands a price that is more than twice that of a gallon of premium gasoline because of some intangible emotional response between the consumer's world view and the value proposition wrapped around their perception of battled water. In some cases it has to do with the simple convenience of ready portability in an off-the-shelf container. In other cases it has to do with an emotional response to staying clean and healthy by, for example, avoiding chemical additives such as fluoride or chlorine often found in tap water.
The point here is that bottled water does not seem to be a price point sensitive substitute for tap water. One is delivered directly to your home for free while obtaining the other requires a trip to the store and a cost of $10 per gallon. Viewed from the vantage of the emotional laden perceptions that drive economic value and what consumers are willing to pay, these are obviously quite different products.
My contention is that understanding this paradox and how different goods are in fact valued by consumers provides the key to overcoming our energy policy dilemma and, in turn, can provide the basis for an openly competitive and vibrant international market for energy resources for the 21st century. But that final leap is for Part III of this post yet to come.