Econ 101: What Happens
When We Subsidize
Alternative energy should be developed
in a free, innovative marketplace Ė not through government planning.
By Gary Wolfram, Ph.D.
Free Market Project Adviser
Feb. 8, 2006
President Bush, in his State of the Union speech, said America was
ďaddicted to oilĒ and the federal government would use billions of
tax dollars to pursue alternative energy sources. Rather than
accepting this at face value, we might ask if the presidentís appeal
to the green coalition makes sense.
¬†¬†¬†¬† First, we are ďaddictedĒ to oil only in the sense that
we use oil to produce goods and services, from plastic action
figures to transportation. The United States uses a large percentage
of the worldís oil because we have an economy that produces $13
trillion per year in gross domestic product. We could reduce
substantially our reliance on foreign oil simply by producing less.
But there are very few of us who think a 20-percent reduction in our
standard of living would be a good thing.
¬†¬†¬†¬† Second, it is not likely that the bureaucrats,
legislators or cabinet members will be able to make use of these
billions of dollars of taxpayersí money efficiently by investing in
alternative energy sources. (I say this even though a friend of
mine, who is very bright, was Secretary of Energy for several
years.) Ludwig von Mises in 1920 pointed out that central planners
will always be faced with an insurmountable information problem in
determining how to allocate resources.
¬†¬†¬†¬† The central planner canít possibly know how much
consumers value different products and the most efficient way to
produce the millions of products. How can the Secretary of Energy
have any idea what types of alternative energy sources, and what mix
of them, is best for maximizing the production of goods and services
in local areas?
¬†¬†¬†¬† When I was in graduate school in the mid-1970s, many
articles and books claimed the world would run out of oil by the
year 2000. Of course, 2000 came along and gasoline prices adjusted
for inflation were lower than they were when those doomsday books
were written. Common sense will tell you that we will not run out of
oil any more than we ran out of whale oil.
¬†¬†¬†¬† As the price of oil rises, the quantity demanded will
fall, and the quantity supplied will rise. The increase in prices
will generate short-run profits, but these profits will attract new
entrants into the field. More companies will go into the oil-finding
business, and the existing companies will find it in their interest
to increase the amount of resources they use in exploring for oil.
Other companies will have the incentive to do things like figure out
how to unlock the oil from sand in Canada or develop some kind of
synthetic oil. This is why we have not run out of oil as projected
by those who ignored the effect of the price system and the role of
profits in a market economy. It is also the reason why we will not
run out of oil in the future.
¬†¬†¬†¬† When the price of oil gets sufficiently high, it will
make sense for entrepreneurs to use their time and talent and risk
their capital in discovering alternatives to oil. It is more than
likely that some alternative energy source will become commercially
viable when the price of oil gets sufficiently high. The greater the
increase in the price of oil the more quickly we will develop
commercially viable alternative energy. Either the oil companies
will find new technologies to make more efficient use of existing
oil or see the advantage of using alternative sources in the face of
rising costs of finding additional oil. New companies will develop
alternative energy sources in an attempt to garner the profits that
will come when people switch to this new energy.
¬†¬†¬†¬† The potential for profits to be made by finding an
alternative to oil are what attract the risk capital of those who
would develop energy that is more stable in supply and cheaper in
price than oil. (Taxing these profits would be the worst thing to do
if we would really like to reduce our dependence upon oil, as it
would be a signal that if you are an entrepreneur and are successful
from taking on enormous risk, then the government will tax away your
¬†¬†¬†¬† If the federal government subsidizes the development or
use of alternative energy, then it will create the wrong incentives,
and the more the federal government spends in this arena, the worse
things will be. The political entrepreneurs will take the lead.
Those who are connected enough to the government to get the
subsidies will make the profit. There is no reason these firms will
be producing an alternative that consumers will find beneficial.
There is every reason to believe these firms will be producing a
technology that those with political power most favor. Rather than
spending resources trying to please consumers, firms will spend
resources trying to please those who control the billions of dollars
of taxpayer money.
¬†¬†¬†¬† If the federal government really must subsidize
alternative energy, it should simply offer a prize of $1 billion to
whoever can produce an alternative energy source that can meet
certain performance conditions. Picking and choosing who is to get
the money based on the government bureaucratís best guess cannot be
efficient. Let the entrepreneurs take the risk and enjoy the rewards
for satisfying innovative performance criteria.
¬†¬†¬†¬† Even so, such a contest would not be the best use of
our resources. Simply letting the market system, which has created
the greatest standard of living for the poor ever seen, work would
ensure us that we will be using the mix of energy resources that
will most benefit society.
¬†¬†¬†¬† This is not rocket science by any means. Adam Smith
explained well more than 200 years ago that in a market system
individuals pursuing their own self-interest will lead to the
greatest benefit for all in society. Mises and Nobel Laureate F.A.
Hayek explained why governmental control over resources cannot
produce wealth for the masses because government planners can't
solve the problem of decentralized knowledge. Another Nobel Prize
winner, James Buchanan, explained why the incentives involved in a
governmental system would result in the resources going through that
system being directed to those with the most political connections.
Why would we ignore these great economists and think that the same
government that brought us FEMA and Halliburton contracts would
successfully use our money to find the ultimate alternative energy