Review of Ames et al.’s (Yale Graduates in Energy Study Group) “The Arithmetic of Shale Gas” by Matthew Rousu
This study isn’t a “traditional” economic impact study – but this study attempts to estimate the economic benefit to consumers of decreased prices. The authors do this by estimating the consumer surplus gained due to price reductions in natural gas. We provide a brief comment here under the assumption that the authors price and quantity estimates are all correct. (We can make no claim on those, although we assume their correct.)
What is consumer surplus? Consumer surplus, which is taught in introductory microeconomics courses, is the difference between the maximum a consumer is willing to pay and the amount he or she actually has to pay for a product. The higher a consumer surplus, the better – it means consumers are getting products for a lower price than what they’re willing to pay. To estimate the economic benefit to consumers of Marcellus shale – the authors attempt a rough calculation of the additional consumer surplus based on the assumption that the price decreases in natural gas recently were caused by shale gas.
The most important part of this paper is on page 8. By examining the decrease in price from 2008 to 2011 ($4.02 decrease) and multiplying it by the 2008 consumption level (over 25 billion units), the authors find an increase in consumer surplus of just over $100 billion dollars. This staggeringly high impact is the increase in consumer benefits. This simple calculation of the consumer benefit is correct under the following conditions:
1. The decrease in price is attributable to shale gas production. If there were other reasons causing part of the decrease in price, then the consumer surplus (benefits) wouldn’t be as high. On a related note, if the price actually would have risen without the Marcellus shale production, the increase in consumer surplus could have been more than $100 billion.
2. The price and production levels varied across years … The authors are assuming that prices and quantities would match up reasonably well even in the same year. On page 8 they use 2011 price reductions with 2008 quantities. The 2010 prices they show on page 4 seem higher, however, which would mean a lower consumer surplus. Using the 2008 quantity with the 2010 prices seems like it would yield a significantly lower consumer surplus of in the range of about $60-$85 billion. This is still a huge benefit to consumers – but far lower than the $100 billion surplus they found for 2011.
3. The authors ignore the fact that by the price of natural gas dropping and consumers switching to natural gas, it may decrease demand and put downward pressure on the price for other forms of energy. That may actually cause a higher overall consumer surplus than the authors are estimating.
The authors also make a rough attempt to estimate (only) the external social costs of Marcellus shale drilling. They are correct to exclude most of the (internal) costs – as the price contains the cost information. They examine costs from potential externalities, like groundwater contamination, spills, etc. The authors appear to attempt to overestimate the potential costs, by assuming that 1/100 wells will require cleanup of spills that will cost $2.5 million per well for a total cost of $250 million dollars. I think that’s an overestimate, but the authors don’t include anything to calculate the costs of a potential “black swan” event – an event that is immensely costly but we’re not considering. However, given that they likely overestimated the cost per cleanup, their $250 million estimated social cost per year figure may be accurate. Even if they’re off by a factor of 10 (i.e., the social costs are really $2.5 billion annually) – the social costs appear well below the consumer surplus benefits.
The authors use simple arithmetic to estimate the consumer benefit of shale gas drilling. They find a consumer benefit of over $100 billion. To engage in a rough cost-benefit analysis, the authors attempt to estimate social costs of drilling as well, estimating them at far less than $1 billion. The authors use several assumptions to arrive at both of these figures, but none of the assumptions seem unreasonable. Even if their assumptions are too optimistic, the authors make a convincing case that the consumer benefits far outweigh the social costs.