I don’t get this (anymore)

Peak Oil is the idea that the economy is heavily dependent on petroleum and we are getting close to pumping all of the stuff out of the ground. Thus, catastrophe.

The typical economist’s response is that the dwindling supplies will increase the price of oil. This will make substitutes more attractive and it will induce innovations, generating new or better substitutes. Then comes the part I don’t get. Then, the economist will say, we shouldn’t worry about Peak Oil.

How, dear economist, do increased prices translate to more innovation? There’s no magical price-to-invention machine that produces these innovations. If people don’t “worry” about higher prices of oil, they won’t be induced to innovate. Telling people “innovation happens” removes the incentive to innovate!

Economists can tell you a simple supply and demand story (supply goes down, prices go up) or a more fancy dynamic resource extraction story. They can even tell you a pretty convincing story for what sort of policies and institutions have created incentives that seemed to have induced innovation in the past. They can tell you what goes in the black box and what comes out. But they can’t tell you a damned thing about how that innovation will actually happen.

16 thoughts on “I don’t get this (anymore)”

  1. The problem is the term “worry”. If worry = “lobby the government to do something”, then the statement is correct. If worry = “change my individual behavior in any way”, then the statement is wrong.

  2. Some things to think about:

    British blockade, Napoleon and the sugar beet. Now, I don’t know how much innovation took place, but with any kind of learning by doing, no sugar cane will mean more experience growing other crops. But then again, sugar beets have been protected ever since, so it’s not a great example. Also, this is a drop in quantity, which could be different than a drop in price (think quota versus tariff).

    The US South during the civil war and cotton spreading to Egypt and India comes to find too, but I don’t know how much innovation was required to bring cotton to new regions.

    Oil crisis lead to Brazil investing heavily in ethanol. That was government led research in a dictatorship, and the program looked like a failure once oil price crashed in the 1980-90s, but ex post it is quite popular and successful in reducing dependence on foreign oil.

    Also, any model or story with high prices leading to high innovation requires innovation to be mostly driven by a profit motive. Greg Clark would disagree strongly, at least for the major innovators of the Industrial Revolution.

  3. Also – what kind of innovation (if any) happens when a good’s price is protected by the government? I’m thinking of some oil producing countries where the oil companies are government run, and the price of gasoline is heavily subsidized. An entity would only think to innovate if they expected supply problems later…

  4. Kevin, what if you have a great idea but the start up costs are really, really government-sized big?

    Piero, I’m not a Clarkian. I think incentives matter. I just think that economists saying “innovation happens” reduces incentives to innovate.

    swong, yeah that’s the usual argument. Its also the argument against stupid government policies. I’m arguing that outside-in stories (macro stories) from economists confuse the subject.

  5. Now, there are a few overlapping questions here that I think are interesting…

    (1) Do we have any reason to believe that the world can maintain the same level(s) of welfare after all the oil has run out [or prices into very limited use]? — I think the honest answer is no, it could go either way.

    (2) Will the transition from the current state of things to the post-oil era be efficient? I.e., will we do as good as we could?

    Economists’ story is mostly about (2), i.e. we will transition as well as possible, but it could still suck, see (1).

  6. Re: innovation, are there technologies that can generate the same amount of energy as oil with engines of comparable size? Are those technologies powered by resources in considerable supply? If yes and yes, it’s just a matter of getting prices right, no?

  7. Good points Gabriel. Past experience tells us (2) is most likely to happen (e.g. coal->oil). Suppose, though, I, as an economist, tells a friend, a petroleum engineer, this story. What is the likely effect of him having this bit of economic insight? Is he more or less likely to invent the next source of energy?

    I’m not arguing the truth value of (2). Clearly, economists tell a true story, but it is partial equilibrium. I’m wondering if the sociological effects feedback in general equilibrium. Does dissemination of the economic story retard innovation? Who picks the $100 bills up off the sidewalk? Is this effect important empirically?

  8. “But they canโ€™t tell you a damned thing about how that innovation will actually happen”

    Exogeneous growth ๐Ÿ˜€

    Can’t you just say that people invest in R+D to make future expected discounted profits? With higher prices for traditional energies, new energy sources can have a higher price and/or larger market share. This increases future expected profits and thus spurs more innovation. What’s wrong with this model?

  9. pushmedia1, do not worry. Scientists don’t do research because of the needs of humanity, they do it because of their own needs. — I find sublimation to still be a good “model” of fundamental research, academia, etc.

    Some people will work on a problem because the problem is out there and they understand it and it titillates them in funny places. That’s sufficient.

    Sure, you might more careerist folks on it too, but , hey, I take what I can.

  10. I don’t see what the problem is, theoretically speaking. Everyone’s actions are already taken into account when we formulate the supply and demand curves.

    “Suppose, though, I, as an economist, tells a friend, a petroleum engineer, this story. What is the likely effect of him having this bit of economic insight? Is he more or less likely to invent the next source of energy?”

    Neither. When you say that the price will increase (due to the demand curve shifting right) you’re assuming he’s going to behave in the profit-maximizing way, therefore you can take his actions as given, therefore he’s part of the supply curve. And he already knows how consumers will behave, they know how he’s going to behave, he knows that they know, etc.

  11. To your question on large-sized innovation, I don’t see why the government is an advantage. I actually think they are better suited to small research grant dispensing. The bigger the government program, the more rent seeking it induces, which decreases the likelihood of a good outcome. So unless you have a problem that is so compellingly existential it can overcome rent seeking behavior, I don’t believe there are large innovation programs where the government is better than private industry.

  12. ssendam, I’m asking what his behavior would be in the market for innovations. He would be less likely to study alternative energies in grad school. He’d be less likely to get a job at new energies research firm, etc. This decreases the supply of innovations.

    Innovation happens when innovators ignore economists talking about equilibrium outcomes. The same thing is true in competitive markets where profits are competed down to zero (so why would there be entry?), but here I think the psychology of innovators is especially important as an incentive to innovate.

    Kevin, I agree. It is efficient to have government fund innovation if the benefits are greater than the costs, taking public choice issues into account.

  13. I think perhaps the “not worrying” is more for the general populace. We should be telling the engineers to worry, I agree.

  14. Worry is the wrong word all together. Worry won’t drive innovation, but the potential of fortunes to be made. As the price of oil increases, so will the financial gain potential for someone who produces a viable alternative.

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