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Consumer surplus and electricity markets

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"Consumer surplus and electricity markets"

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When compared to the value of the service they provide, U.S. electric rates are an astonishingly good deal

Richard-Caperton-smallRichard W. Caperton begins the first in a weekly series of articles on how utility decisionmaking, regulatory structures, energy markets, and consumer behavior all impact the massive deployment of renewable energy and energy efficiency products. Caperton is a Senior Policy Analyst at the Center for American Progress.

My colleague Matt Yglesias recently made an important point about how competitive markets can benefit consumers:

Think about your standard refrigerator/freezer. It’s sort of a miraculously useful device. Instead of your food turning stinky and rotten, it sits nicely in my fridge. The direct financial value of being able to store leftovers or freeze excess raw ingredients is significant, over and above the convenience value. You can spend a lot on one of these miraculous devices if you’re so inclined, but you can also get one for a few hundred bucks. That’s because the market for fridges is quite competitive””lots of different manufacturers, lots of different vendors””so at the less stylish end of the market, the sale price approximates the construction costs. And the construction costs are low, crazy low relative to what you’d be willing to pay to a refrigerator monopolist. If the cheapest fridge out there cost $5,000 I’d still want one and I bet you would too.

Consumer surplus – the extra value that consumers derive from a product that is above and beyond the price they paid – is an incredible economic tool.  In fact, it’s even codified in US regulatory proceedings.  The Office of Management and Budget says that consideration should be given to both consumer and producer surpluses when examining new regulations.  As consumers, we generally prefer consumer surplus, which is why we’d rather pay $500 for a refrigerator, even though Yglesias may be willing to pay $5,000.

Healthy competition in the appliance market has undoubtedly led to massive consumers surpluses.  It turns out that electricity markets, which are largely based on a unique “regulated monopoly” model, also provide for consumer surplus.

Consider this:  The average American residential consumer pays about 11.5 cents per kwh for electricity.  Yet, we would be willing to pay as much as 100 times that amount in a completely free market!  For example, researchers at the University of Maryland found that the average “value of lost load” (i.e., the maximum price people would be willing to pay for electricity to avoid an outage) is between $2.40 and $20.00 per kwh, or 20 to 200 times as much as the average retail rate.

Of course, value of lost load studies are based on what someone would pay to avoid an outage, so people may not be willing to pay these prices in the long-term.  Put another way, once you’ve already installed lights in your house, you’re probably willing to pay extremely high rates for short periods of time to keep them on, but the decision to install lights is based on expectations of low rates.  If you expected extremely high rates, you probably wouldn’t install as many lights.

Lost in all the debate about how much power from clean energy sources would cost, and how environmental compliance affects rates, is that our electricity is an astonishingly good deal.  Even if clean energy did raise electric rates, which isn’t completely certain, there’s absolutely no indication that rates would go up enough to make any meaningful difference in the level of consumer surplus.

It’s also important to note that this consumer surplus is a direct result of a regulatory system that is designed to provide reliable power at the lowest possible cost.  The system has been tweaked over the years, and is certainly far from perfect, but it is sort of incredible to think that we have exceptionally high-quality electricity in our homes at about 1/100th of the price that we would be willing to pay.

This success story makes me optimistic that we can build new things into our regulatory system, like the need to dramatically de-carbonize electricity generation.  I’m confident that policymakers – with the help of engineers, economists, and other experts – can design a regulatory system that will work for the future.  The challenge seems to be in making them understand the high cost of failing to do so.

Richard W. Caperton

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6 Responses to Consumer surplus and electricity markets

  1. sault says:

    Consumer surpluses are all over the place. Clean drinking water is pretty much fungible in this country, so much so that I flush my toilet with water that is ready to drink. But the complete elimination of water-borne diseases and that commie plot to keep our teeth from rotting out by putting Fluoride in the water probably has over a 50-to-1 benefit to cost ratio. It’s good that the government (mostly) provides the drinking water because it’s society as a whole that benefits from the consumer surplus.

    I would also propose the idea of consumer deficits associated with certain products and activities. Cigarette smoking probably causes a net cost to society that is a significant fraction or maybe even higher than the gross (and it is GROSS) addition to GDP that making and selling cigarettes produces. Fossil fuels most definitely have a consumer deficit in the long term, but a lot of people have made themselves obscenely rich through their extraction and consumption up to now. This is the problem of incumbency that is holding clean energy back.

  2. Dan says:

    Richard,
    It would be fascinating to hear you describe the role of electricity regulation (and deregulation) in forming this consumer surplus. Your talk about “value of lost load” reminds me of the california electricity crisis. Is there any evidence that the semi-monopoly status of utilities is ensuring an efficient allocation of goods?

  3. mightyDrunken says:

    A similar thought has been running around my mind like a highly energetic kid. If you think about it, electricity is incredibly useful. It powers not only many highly useful machines like the refrigerator and lights, but now the ubiquitous phones and computers.Then there is the incredible utility it has in (almost) all of industry.

    Electricity is cheap, very cheap. In this backdrop wind and solar are in an uphill battle. If global warming did not exist we would naturally progress to renewable power when fuels started to rise ever higher in price. Now we instead need to nudge the market to make that transition happen earlier than it would naturally occur in the market.

    The economy can bear a higher price of energy but it does need time to adjust. If some interest groups get there way we will be unprepared for the natural rise in energy costs and the result of our past energy production. It is not the clean energy advocates which are likely to harm our future energy economy but the fossil fuel do nothing advocates.

  4. Mulga Mumblebrain says:

    Consumer surplus becomes more crucial as wages decline, as conditions are stripped away, as more and more family members are forced to seek work, and as personal and household indebtedness soar. The precarious situation of tens of millions of US households is a recipe for social unrest, so far masterfully diverted by the ruling elites into lunatic crusades like the Tea Party, where the Mad Hatter turkeys are setting out to bring all the bosses’ Christmases at once, by actively agitating against their own economic and social interests as if they were the plutocrats themselves, and not just a sad rabble of serfs.
    The Chinese have been exceedingly generous to the US, first by providing billions in cheaper and cheaper goods, that are keeping US living standards somewhat afloat, by being sold by low price outlets like WalMart, producing a good deal of consumer surplus. Of course the irony is that WalMart employees are so lowly paid, like millions of other US workers, that they must shop at WalMart to keep up appearances. Even so they have become mired in ever deeper debt, a good deal incurred to buy houses at the peak of the boom, which is still unraveling. So much equity has been lost in this bust that millions have been reduced to debt peonage. And China has also been singularly generous, if not disinterested, in buying trillions in US Treasuries, which look more and more like turning into worthless wall paper as time goes by.
    In Australia the question of electricity prices is being cynically manipulated by the denialist Right to attack both a ‘carbon price’ and renewables. The recent great increase in electricity prices is mostly due to the private business oligopolists who took over these industries when they were privatised, acting like capitalists. In other words they are seeking to maximise profits, by gouging the suckers, I mean ‘customers’, in order to enrich themselves, and to pay the large sums borrowed to finance their purchase. But we hear none of that, naturally. No, of course, the increased price is all due to ‘morally vain’ urban greenies buying solar photovoltaic rooftop arrays, which have been subsidised, thereby hitting the poor and lower class electricity consumers. The Right here has a touching tendency to suddenly develop a tender concern for the poor, or Aborigines, when they can be turned against environmentalists. At all other times they treat them with contempt.

  5. David B. Benson says:

    The recent experience in Japan and for rather longer in Germany suggests that electric power demand becomes quite elastic at around 30 UScents/kWh.

  6. Mike # 22 says:

    “The challenge seems to be in making them understand the high cost of failing to do so.”

    Very high cost. Sheer lunacy to proceed as we are. They should understand, but they do not act that way. So there is a missing factor, something they fear more than Hell and High Water.