25 Jan 2012

Externalizing the internality

Behavioral economists have a new twist on the old idea of "internalize the externality" (e.g., include the cost of pollution in the price of gasoline), i.e., "externalize the internality."

By this, they mean call attention to something important that we tend to ignore because it's hard to vizualize internally.

I will be reviewing Ariely's book on these ideas soon, but the important point is that "free" distorts our behavior: we spend too much on "free" things ("buy one, get one free") in the same way that we do not pay attention when a 100 percent price increase is from trivial to "double-trivial," e.g., when water goes from $0.001 per unit to $0.002 per unit.*

Both prices are too cheap to notice (the internality), so we fail to change (externalize) our behavior.

There are two ways around this:
  1. Get people to notice how much water they use relative to their neighbors (like here).
  2. Raise prices to a level that's "noticeable" (e.g., $4/gallon gas) and rebate excess revenue to customers who use less than average volumes (people really notice refund checks!).
These externalizations will change our habits in two ways. First, people will reduce their demand because they are paying attention (wait -- there's a price?). Second, they will reduce their demand if the price is higher (ohhh -- and it's higher!).

Bottom Line: Prices only work when we notice them, so make water prices (and consumption) relevant.

* Residential water often costs $1 for 1,000 liters/250 gallons.


GSS said...

David - you are right on the mark here. People will not notice their water bills until reaching some "care point". Once we get there, people will demand tools to manage their own behaviour - tools which most utilities can't provide - real time consumption data, alerts on consumption and costs etc.

You are also right that rewarding conservation works. Our rebate threshold rate does just that - and combined with the Smart Grid for Water AMI tools we deploy, consumers now can actively control their consumption.

We are seeing lower consumption - and lower costs for consumers - even though our Commission approved a "large percentage increase" for our utilities. What is also interesting is that we saw one utility's rates be reduced by approx 30% and we saw an immediate 20% increase in consumption.

Janice Beecher said...

Thanks David. How we deal with externalities is critically important. There is litte doubt that what we pay for utilities and other goods and services does not reflect true value or the impact of our consumption. In my view, true externalities beg for public policy. The answer is far more complicated than just "raise the price." This is especially critical in the case of monopolies that provide essential services. Overpricing is as much a problem from an efficiency viewpoint as underpricing, and can simply enrich the monopolist at the expense of captive customers.

See my thoughts on the subject here:

Janice Beecher said...

ps - We are seeing declining demand for water across the board. This is good news! Pricing does work - and average prices may be the driver as much as marginal prices (per GSS's observations).

Janice Beecher said...

pss - (sorry). All that said, I do believe that externalities in terms of increasing marginal costs can be incorporated into revenue neutral rate design.

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