Behavioral Economics

Dan Areily’s new book “Predictably Irrational: The Hidden Forces That Shape Our Decisions” seems to be getting a lot of press lately, having been reviewed in newspapers and Dan having been interviewed on NPR. It is the subject of a review, written by Elizabeth Kolbert, in this week’s New Yorker. Ms. Kolbert is the author of “Field Notes from a Catastrophe,” an anecdotal book about climate change (which I recommend by the way), but she does not link the two issues in the review.

Dan Areily’s book is a popular one on the subject of Behavioral Economics, which studies what people actually do when faced with economic choices rather than what Adam Smith thought they should do. It turns out that we are not very rational, and that calls into question the validity of a lot of classical economics. The invisible hand might be blind also, and maybe a bit tipsy. I got to thinking what this might mean for carbon pricing. (I should perhaps add here that I have yet to read the book, so this thinking might be premature.)

As discussed last week, a “sensible” price for carbon emissions is probably in the $10 to $50 range per metric ton, which translates into 10 to 50 cents on a gallon of gas or 1 to 5 cents per kilowatt hour on the electricity bill. This extra cost is meant to provide: the power company with an incentive to develop alternative energy sources; industry to find less energy-intensive ways of making products, and indeed entirely new products which use less energy; and consumers to demand and buy products which use less energy and to otherwise alter their life styles to use less energy. Furthermore, if classical economics holds sway and we all behave rationally, it is meant to cut emissions in a way that does least damage to our standard of living. But will it work?

We can probably rely upon industry to do its bit. At least we should hope that well-run corporations make their decisions on a rational basis. Fortunately their rationale includes their desire to look good, so if anything they are probably going to put more emphasis on going green than would be warranted by a strict calculation of the cost. Right now there is no cost, but companies are already beginning to behave as if a carbon tax or a cap-and-trade system were in place. This is partly because a lot of their decisions have long-term consequences, but also because of the public relations benefits.

As an example of this, I read somewhere that over half the coal fired power stations that were planned in 2000 have since been cancelled. Carbon Moratorium Now (www.cmn.org) reports that 59 such stations were cancelled in 2007 alone, while here in Texas (where we have more wind power generation on line than any other state), 8 of the 11 coal-fired stations planned by TXU were recently cancelled as a condition of its prospective new owners.

But what about us consumers? Here are a couple of statistics:

74% of Americans believe high gasoline prices are a "serious" or "somewhat serious" problem. (Source: Quinnipiac University Poll. June 5-11,
2007), and

81% of Americans believe gasoline prices are "unreasonable." (Source: CNN/Opinion Research Corporation Poll. May 4-6,
2007.)

Yet:

64% of Americans would be willing to pay higher gasoline/fuels taxes to support development of alternative energy sources. (Source: CBS News/New York Times Poll. Apr. 20-24, 2007.)

It is hard to think that we will change our habits because of a 10 cent increase in the price of gas, especially as this is dwarfed by recent increases due to normal demand and supply issues. But we are changing our habits. Prius outsold Explorer last year, and I saw my first Smart ForTwo in Houston last week. I was gratified to see two hybrids in the paddock of a vintage car race meeting at the weekend, showing that even us petrol-heads are concerned. (This was a casual observation; I was not looking for hybrids, let alone counting them. I just happened to notice the inconspicuous badges on these Hondas.)

I doubt that it is the possibility of another 10 or even 50 cents on a gallon of gas that is motivating people though. For now, I think the irrational motivations – by which I mean motivation not based on pure self interest – is working in favor of conservation rather than against it. Let’s keep it that way!

But if consumers don’t do our bit, industry will take up the slack in a cap-and-trade system. The solution will be a little less than optimal, measured in strictly economic terms, but one could argue that if we are happy with our choices then by definition they were the best.