Production Possibilities and the U.S. Macroeconomy

A key finding of the CEF study was that “there are large-scale market and/or organizational failures, in addition to potentially substantial transaction costs, that prevent consumers and firms from obtaining many energy services at least cost.” Moreover, “interpreted in a macroeconomic context, the . . . economy is not on its aggregate production-possibilities frontier.”^a

The production possibilities curve describes the alternative combinations of final goods and services that can be produced in a given time period with all available resources and technologies (see figure below).^b Points on the curve (points A and B in the figure) represent the maximum level of output that can be produced with a given set of inputs and technology. However, there are multiple ways in which these inputs can be combined to produce any given set of products or services. Movement along the curve introduces another concept, opportunity cost. The opportunity cost reflects a tradeoff in the production of the economy, i.e. to produce more of a product, given a fixed set of inputs, the economy must produce less of something else, or a combination of other goods and services. Points inside the curve (point C) mean that the economy is not fully utilizing its resources and that more goods and services can be produced from the given set of inputs. Points along the curve are said to be “efficient” in the use of a given set of inputs and technologies, while points inside the curve are “inefficient.” Production outside of the curve (point D) is not attainable given current resources and technology (see Production Possibilities Curve graph).

As Appendix E-4 of the CEF study stated, “. . . many of the criticisms of studies like the CEF are a disagreement with the extent to which the economy is inside its aggregate production frontier, the effectiveness of policies to overcome this situation, or both.” The debate also relates to movements along the curve which represent the opportunity cost of changing the mix of goods and services in the economy. The crucial assumption underlying the CEF study was that the economy is not currently on its production possibility curve, i.e., the economy is not using its resource base efficiently. Moreover, the study assumed that a least-cost technology modeling approach can yield a measure of the energy cost savings which permits the economy to move outward to the production possibilities curve frontier. However, to do so requires overcoming “large-scale market and/or organizational failures, in addition to potential substantial transaction costs, that prevent consumers and firms from obtaining many energy services at least cost.”

Therefore, by assumption, CEF presumed that the economy is operating at a position which is not on the stylized “production possibilities curve” and that overcoming market failures in the use of energy can both make the economy more energy efficient (to the position defined as the moderate case) and actually increase GDP at the same time. This assumption was flawed by CEF assumptions that energy markets currently are not behaving efficiently and that any of the market barriers that may exist are, in fact, market failures instead, as discussed below. The distinction is important, because as Henry Jacoby points out, “The key difference between market barriers and market failures is that correcting failures may sometimes produce a net benefit, whereas overcoming barriers always involves cost.”^c

However, as discussed in presenting the energy market assessment in this study, many of the presumed “market failures” are actually rational, efficient decisions on the part of consumers given current technology, expected prices for energy and other goods and services, and the value they place on their time to evaluate options. Consumer preferences for certain attributes of energy-consuming equipment, for example, larger cars or houses with increasing use of miscellaneous electric appliances, are consistent with making efficient household decisions. These may represent “barriers” to the adoption of certain energy technologies, but this does not constitute a market failure which prevents the economy from operating on the efficient portion of the production-possibilities curve.^d Also, many of the programs which are promoted to overcome a market failure overstate the case. Incorrect information can indeed lead consumers to make wrong choices, but benefits of information programs and voluntary initiatives are difficult to quantify.

It is also appropriate to consider a movement along the production-possibility curve to a position that society may deem to be more desirable, for example, one with a lower level of emissions. This is done most often through a change in energy prices vis-a-vis other goods and services, which changes the mix of production and consumption in the economy. However, the carbon trading fee that attains this mix is dependent on the location of the economy relative to the production-possibilities curve. If one presumes that the economy has an alternative reference case with lower emissions, the task of attaining a lower emissions target is lessened. By making this assumption, the CEF authors effectively lowered the projected cost of meeting the more stringent emissions targets.

^aInterlaboratory Working Group, Scenarios for a Clean Energy Future, ORNL/CON-476 and LBNL-44029 (Oak Ridge National Laboratory, Oak Ridge, TN, and Lawrence Berkeley National Laboratory, Berkeley, CA, November 2000), Appendix E-4, “Estimating Bounds on the Macroeconomic Effects of the CEF Policy Scenarios,” web site www.ornl.gov/ORNL/Energy_Eff/CEF-E4.pdf.

^bB.R. Schiller, The Macro Economy Today, Eighth Edition (New York, NY: McGraw-Hill, 2000), pp. 7-10.

^cH. Jacoby, “The Uses and Misuses of Technology Development as a Component of Climate Change Policy,” presentation to the America Council for Capital Formation, Center for Policy Research (October 1998).

^dFor a good discussion of the distinction between market failures and market barriers, see H. Jacoby, “The Uses and Misuses of Technology Development as a Component of Climate Change Policy,” presented to the American Council for Capital Formation, Center for Policy Research (October 1998).