Lynne Kiesling

Ted Gayer of the Brookings Institution and Kip Viscusi of Vanderbilt University have a new Mercatus working paper that is a careful and thoughtful critique of the rationale, the methodology, and the outcomes of federal energy efficiency regulations. Using standard Pigouvian externality theory, most environmental regulations are based on the “market failure” rationale that individual actions create unaccounted-for and uncompensated costs. Gayer and Viscusi begin their argument with the claim that such a rationale for regulation is indeed valid, to the extent that such costs exist. It also matters whether or not those costs are relevant at the margin — would imposing a tax for a cost or a subsidy for a benefit change the individual’s actions in ways that would account for the externality? If not, then it’s an irrelevant externality.

In the case of a relevant externality, we use benefit-cost analysis (BCA) to evaluate policy proposals that are intended to move from the existing outcome toward a more efficient outcome by changing individual incentives and choices. Gayer and Viscusi provide a clear, succinct summary of BCA’s analytical framework. Much of their subsequent argument hinges on something important that they point out early in the paper: while it’s possible that individuals don’t fully take into account the effects of their actions on others, we still assume that the individual is in the best position to evaluate the likely net benefits they will obtain across a range of alternatives. I’ve phrased this statement of rationality quite generally — it doesn’t require full information, nor does it require perfect foresight. All of the rationality that is required to support the consumer sovereignty at the core of BCA is that the individual is better positioned than any other person or set of persons to perform that evaluation.

Here’s where the Gayer and Viscusi analysis is very useful, because from here they open up a critique of how regulatory agencies use the consumer irrationality interpretations of behavioral economics as a further rationale for regulation. This is common practice, and one that I find analytically unacceptable. Moreover, I think it’s common practice in energy policy analysis to conflate the “market failure” argument and the “consumer irrationality” argument; for example, several years ago I attended a talk in which the author took the empirical finding that consumers have high discount rates for vehicle fuel savings (typically they value three years worth but not beyond), and he labeled that fact as a “market failure”! To this day I wish I had challenged him on that false conflation.

This sovereignty/irrationality point is a crucial core of the normative arguments and justifications for legitimate policies and regulations, and it’s an argument that isn’t well-made often enough. Gayer’s and Viscusi’s contribution here is important. They note that

If BCA abandoned the presumption of consumer sovereignty and replaced it with another assumption about the systematic behavior of consumers, it would lead to the normative implication that the analyst or policymaker decides what is best for each consumer. Given the informational and analytical challenges of finding behavioral failings among heterogeneous individuals, this is a tall order for any analyst or policymaker, especially given that they are also prone to information and behavioral failings. A principal theme of Viscusi’s book, Rational Risk Policy, is that government regulators often institutionalize individual irrationality because policymakers are human and because the pressures exerted by their constituencies push policies in directions away from rational norms. (pp. 7-8)

Here Gayer and Viscusi argue in the spirit of robust political economy — humans have cognitive limitations both in their individual decision-making and in the institutions they design and the political/policymaking roles they perform. Their analysis in this paper presents an argument, and provides supporting evidence, that individual sovereignty should remain our analytical standard in the BCA methodology that regulatory agencies implement to evaluate policies. As they state, this standard implies that

A shift away from the principle of consumer sovereignty will also lead to regulations focused more on correcting self harm than on internalizing environmental harm. For example, it would place greater weight on regulations that ban energy-inefficient products than on regulations that raise the price of pollution. … Therefore, the burden of proof for any BCA conducted as part of a review of regulatory proposals should be placed heavily on justifying any presumption of a deviation from consumer sovereignty. The agency preparing the BCA needs to demonstrate a systematic deviation from consumer rationality rather than just presuming that the regulator is better equipped to make decisions that protect individuals from themselves. (pp. 8-9)

They then evaluate four specific applications of energy efficiency policies designed to close the “energy efficiency gap” — the high discount rate implicit in the tradeoff facing consumers between near-term capital costs of energy-efficient devices and longer-term energy savings (as in the example I alluded to earlier). In evaluating energy efficiency regulations for vehicles (CAFE standards), room air conditioners, clothes dryers, and incandescent light bulbs, they examine both the academic literature and agency analyses to see whether the regulations internalize environmental harm or correct self-harm, to use their language.

Their analysis of agency (and, by implication, national lab) studies shows a recurring pattern of emphasis on engineering analyses that compress the treatment of consumer benefits into energy-efficiency-focused dimensions and ignore other aspects of consumer preferences. For example, in performing vehicle analyses, regulatory studies will incorporate data on the transportation function of the vehicle, fuel costs, and the energy efficiency of the vehicle. Omitted from the analyses are variables like comfort, number of seats, volume of cargo capacity, mortality statistics and safety ratings, maintenance ratings and costs, and performance variables such as acceleration. Omitting these variables from the analysis implies that the agency’s policymakers do not believe that such variables should factor in to consumer technology choices, and that energy efficiency is the most important variable. Gayer and Viscusi argue that agencies should make that argument based on evidence of external costs and market failure, and not based on arguments that policymakers know better than individuals what choices are most in their self interest.

My summary does not do their argument justice; the entire paper is well worth your time. Mercatus has also generated some policy briefs to accompany this longer paper: this four-page policy brief that summarizes the analysis, and this graphic that illustrates their estimate of the effects of energy efficiency regulations. If the purported objective of energy efficiency regulations is reducing environmental harm, this analysis suggests failure.

I would add another arrow to their analytical quiver. Taking as given the cognitive limitations of humans and the evidence we see from behavioral economics, which institutional framework is more likely to lead to more efficient error correction? If their analysis is correct and most of the outcomes of energy efficiency regulation are “protection from self-harm” and not reduction in environmental harm, what’s the most effective means of enabling individuals to correct those errors? Imposition of choice-restricting regulations is less likely to do so than either market processes or, in the cases where the “self-harm” results from incomplete information, regulations that focus instead on providing clear information and comparisons of the effects of different alternatives.