Network Effects and Alternative Fuels

Field of Corn used to Produce Ethanol Gas prices are high, and we still need/want to drive a lot of places. This combination has us looking at alternative methods of fueling our vehicles. One method that has started to catch on is hybrid gas/electric cars, such as the Toyota Prius. These vehicles use gravity to charge a battery that assists the gasoline engine and reduce fuel consumption. Unfortunately, some studies show that these vehicles do not use any less fuel, and the battery is mostly used to give the vehicle more power. Since that is what the market really craves, auto manufacturers are only too happy to oblige.

A second ‘alternative’ method is the use of ethanol fuels made from corn. Since this is not a new technology, people schooled in economics should be extremely wary of such a solution. The reason is simple: if we could have used ethanol fuels all along, why have we stuck with gasoline? The likely answer is that ethanol, in the end, is still more expensive than gasoline. When, and if, gasoline becomes more scarce, that relationship may change, but the current incarnation of ethanol fuel, E-85, which is a blend of 85 percent ethanol and 15 percent gasoline, has yet to catch on. Let’s explore some of the reasons why.

The biggest reason, perhaps, has to do with the economics of networks. Network economies exhibit large consumption externalities as the network size grows. The classic network example is the telephone. The first telephone owner has a completely useless device because there is no one else to call. As soon as there is a second owner, the device becomes useful, but not terribly so. As more and more people buy telephones (and telephone service), the network becomes more and more useful, and the value of the telephone increases. In other words, as each new telephone is purchased, the value of telephones in general increases. Other classic examples of network economies are airlines, who need planes and airports that work together to form a network, and computer software, which needs compatible machines on which to run the software.

As you can see from the above examples, standards are an important part of network economics. When you have two goods that need to work in a network together, they must be compatible with each other. In the early days of rail roads, different companies used different track gauges, so trains could not go from one company’s tracks to another. Once a standard gauge was decided upon, the size, and value, of the rail road network shot upward. Likewise, DVD video renters need rental stores that provide compatible DVDs. If you are an early adopter of a video player that uses the new Sony Blueray technology, you might not have any place to rent movies until Blockbuster or Netflix start carrying Blueray discs.

Thie lack of a compatible standard is a large drag on the ability of E-85 to catch on. Cars need to be E-85 compatible to use the alternative fuel. You cannot simply put ethanol in a gasoline engine without some modifications to make the engine able to burn the fuel. On the other hand, according to the New York Times, the pumps needed to put the fuel into a vehicle cost upwards of $200,000 each when you include the new tanks needed as well. Fueling stations are not willing to install the pumps until there is a critical mass of customers who will buy the fuel, and drivers are not willing to pay for a car that can use E-85 unless there are a lot of stations at which to buy the fuel. According to the New York Times, only 850 of the 170,000 service stations in the US sell E-85, and almost all of them are in Iowa, Illinois, and Missouri. None are in New York or New England. California has one station that carries E-85.

The high costs of providing a standard is preventing a critical mass of consumers and producers from adopting E-85. No one wants to act unless somebody puts a lot of money into the network first. How could we solve the problem? The most common way would be through some sort of government subsidy to make the E-85 cheaper, and therefore incentivize people to adopt the standard more quickly. In fact, we do exactly this already. Ethanol producers receive a tax credit of 51 cents a gallon from the federal government, and states such as Iowa and Illinois are proposing additional state-level tax credits. Another solution is to allow for extra-normal profits on the part of the producer, which will give them the incentive to install the pumps up front. Once the pumps are installed, people will have an incentive to buy the compatible vehicles. The most common way to do this is a government granted monopoly, like with local telephone and cable TV networks.

Both of these solutions are problematic, however, in that they impose a high social cost to using E-85. Monopolies, for the most part, simply transfer consumer surplus to the supplier as well as lose some of the surplus to excess burden. Likewise. the current price supports simply hide the true cost of ethanol production and preclude the creation of new, better technologies. In essence the price supports are a transfer of welfare from the US taxpayers to the suppliers of ethanol, the largest of whom is Archer Daniels Midland. Also, as more and more people demand ethanol, the price will rise from its current level, reversing some of the gains that we might encounter by using E-85. A better solution is to not interfere, let gas prices rise from oil scarcity to the point that they are high enough that ethanol fuel makes sense. People will then buy the cars, demand the gas stations, and suppliers will be happy to comply.