Rent-seeking diary: State dealer franchise laws and Tesla

By now you’ve probably heard that last week the New Jersey Motor Vehicle Commission passed a rule stipulating that automobile sales in the state cannot be direct-to-consumer, and must instead take place via dealer franchises. Tesla Motors was the clear target of this regulation, with its innovative electric vehicles and direct-to-consumer sales model. New Jersey is not the first state in which this regulatory tangle is occurring; last summer Tesla ran into dealer franchise law hurdles in Virginia and New York, as I discussed here in July.

The SF Gate blog post above notes:

Tesla said the administration had “gone back on its word,” claiming two top Christie aides had agreed not to move forward with the regulation. …

But a Christie spokesman rejected the accusations of a double-cross. The regulation, he said, won’t prevent Tesla from seeking legislation to allow direct sales in New Jersey.

Note that the political establishment response is to engage with the political process to get legislation passed to allow direct sales. What would such engagement entail? Will it entail the kind of crony relationships that have led to the entanglement of so many businesses and politicians in the past — will Tesla have to find its own politicians to fund in the hopes of a favorable legislative outcome? If so, that will vindicate my sad statement last July:

When innovative and environmentally correct meets the crony corporatism of existing legislation, is the entrenched incumbent dealer industry sufficiently politically powerful to succeed in retaining their enabling legislation that raises their new rival’s costs?

In New Jersey, it appears that the answer is yes, at least for now, as established car dealers cling to their old business model and hope to avoid being disintermediated. Tesla has thus far avoided the crony trap, and has instead focused on relabeling their New Jersey showrooms as “galleries” while encouraging customers to purchase the vehicle online. Will that legalistic sleight of hand suffice to enable an end-run around status-quo-protecting obstacles?

Alex Tabarrok discusses the Tesla-New Jersey case today, and analyzes it very usefully with a brief history of the evolution of state dealer franchise laws and how they served as a Coasean solution to an incentive problem:

Franchising rules evolved in Coasean fashion so that manufacturers could not expropriate dealers and dealers could not expropriate manufacturers. To encourage dealers to invest in a knowledgeable sales and repair staff, for example, manufactures promised dealers exclusive franchise (i.e. they would not license a competitor next door). But with exclusive franchises dealers would have an incentive to take advantage of their monopoly power and increase profits by selling fewer units at higher profits. Selling fewer units, however, works to the detriment of the manufacturer and the public (aka the double marginalization problem (video)). Thus the manufactures required dealers buy and sell a minimum quantity of cars, so-called quantity forcing. Selling more units is exactly what we want a monopoly to do, so these restrictions benefited manufactures and consumers.

Here Alex’s account dovetails with the history that Elon Musk provided in his open letter to the people of New Jersey on Friday:

Many decades ago, the incumbent auto manufacturers sold franchises to generate capital and gain a salesforce. The franchisees then further invested a lot of their money and time in building up the dealerships. That’s a fair deal and it should not be broken. However, some of the big auto companies later engaged in pressure tactics to get the franchisees to sell their dealerships back at a low price. The franchisees rightly sought protection from their state legislatures, which resulted in the laws on the books today throughout the United States (these laws are not present anywhere else in the world).

Musk’s letter is well worth reading in its entirety, as an eloquent and well-argued statement about regulatory and legislative entry barriers that enable incumbent firms to raise the costs of their rivals. He also provides a thoughtful and economically sophisticated (and accurate, I think) explanation for why they don’t want to sell Tesla vehicles through established dealers.

Here Alex adds another political economy detail of the economic leverage of the franchise dealers in the states — they provided jobs and their sales generated a large share of a state’s sales tax revenue, so politicians found it in their interest to shore up the state-level dealer franchise laws to protect the dealers. Thus a set of laws that initially benefitted both producers and consumers has evolved into industry-protecting regulation.

One other theme I’ve noted in the discussion of Tesla’s reaction to New Jersey cronyism is to criticize Tesla for the benefits it derives from government protection. Tesla’s business intersects with government programs in three areas: (1) taking a DOE-guaranteed loan of $465 million during the financial crisis, which has been paid back in full (and was smaller than the multi-billion-dollar loans to the Big Three); (2) the federal $7,500 income tax credit to individuals purchasing electric vehicles, from which all manufacturers of electric vehicles benefit and which is probably not decisive at the margin for Tesla’s high-income target customers; (3) revenue arising from the existence of a regulation-generated market for vehicle emission credits (ZEV) credits in California, in which Toyota and Nissan also sell ZEV credits to GM and Chrysler. I expect that being practical and not leaving money on the table is a sufficient motive to induce Tesla’s management to engage in those programs. But these benefits from government social engineering and regulation differ in kind from the kind of industry-protecting regulatory cronyism evident in New Jersey (and Texas, and other states forbidding direct-to-consumer car sales).

Permissionless innovation in electricity: the benefits of experimentation

Last Monday I was scheduled to participate in the Utility Industry of the Future Symposium at the NYU Law School. Risk aversion about getting back for Tuesday classes in the face of a forecast 7″ snowfall in New York kept me from attending (and the snow never materialized, which makes the cost even more bitter!), so I missed out on the great talks and panels. But I’ve edited my remarks into the essay below, with helpful comments and critical readings from Mark Silberg and Jim Speta. Happy thinking!

If you look through the lens of an economist, especially an economic historian, the modern world looks marvelous – innovation enables us to live very different lives than even 20 years ago, lives that are richer in experience and value in many ways. We are surrounded by dynamism, by the change arising from creativity, experimentation, and new ideas. The benefits of such dynamism are cumulative and compound upon each other. Economic history teaches us that well-being emerges from the compounding of incremental changes over time, until two decades later you look at your old, say, computer and you wonder that you ever accomplished anything that way at all.

The digital technology that allows us to flourish in unanticipated ways, large and small, is an expression of human creativity in an environment in which experimentation is rife and entry barriers are low. That combination of experimentation and low entry barriers is what has made the Internet such a rich, interesting, useful platform for us to use to make ourselves better off, in the different ways and meanings we each have.

And yet, very little (if any) of this dynamism has originated in the electricity industry, and little of this dynamism has affected how most people transact in and engage with electricity. Digital technologies now exist that consumers could use to observe and manage their electricity consumption in a more timely way than after the fact, at the end of the month, and to transact for services they value – different pricing, different fuel sources, and automating their consumption responses to changes in those. From the service convergence in telecom (“triple play”) we have experimented with and learned the value of bundling. Such bundling of retail electricity service with home entertainment, home security, etc. are services that companies like ADT and Verizon are exploring, but have been extremely slow to develop and have not commercialized yet, due to the combination of regulatory entry barriers that restrict producers and reinforce customer inertia. All of these examples of technologies, of pricing, of bundling, are examples of stalled innovation, of foregone innovation in this space.

Although we do not observe it directly, the cost of foregone innovation is high. Today residential consumers still generally have low-cost, plain-vanilla commodity electricity service, with untapped potential to create new value beyond basic service. Producers earn guaranteed, regulation-constrained profits by providing these services, and the persistence of regulated “default service contracts” in nominally competitive states is an entry barrier facing producers that might otherwise experiment with new services, pricing, and bundles. If producers don’t experiment, consumers can’t experiment, and thus both parties suffer the cost of foregone innovation – consumers lose the opportunity to choose services they may value more, and producers lose the opportunity to profit by providing them. By (imperfect) analogy, think about what your life would be like if Apple had not been allowed to set up retail stores that enable consumers to engage in learning while shopping. It would be poorer (and that’s true even if you don’t own any Apple devices, because the experimentation and learning and low entry barriers even benefits you because it encourages new products and entry).

This process of producer and consumer experimentation and learning is the essence of how we create value through exchange and market processes. What Internet pioneer Vint Cerf calls permissionless innovation, what writer Matt Ridley calls ideas having sex — these are the processes by which we humans create, strive, learn, adapt, and thrive.

But regulation is a permission-based system, and regulation slows or stifles innovation in electricity by cutting off this permissionless innovation. Legal entry barriers, the bureaucratic procedures for cost recovery, the risk aversion of both regulator and regulated, all undermine precisely the processes that enable innovation to yield consumer benefits and producer profits. In this way regulation that dictates business models and entry barriers discourages activities that benefit society, that are in the public interest.

The question of public interest is of course central to any analysis of electricity regulation’s effects. Our current model of utility regulation has been built on the late 19th century idea that cost-based regulation and restricting entry would make reliable electric service ubiquitous and as cheap as is feasible. Up through the 1960s, while exploiting the economies of scale and scope in the conventional mechanical technologies, that concept of the public interest was generally beneficial. But by so doing, utility regulation entrenched “iron in the ground” technologies in the bureaucratic process. It also entrenched an attitude and a culture of prudential preference for those conventional technologies on the part of both regulator and regulated.

This entrenchment becomes a problem because the substance of what constitutes the public interest is not static. It has changed since the late 19th century, as has so much in our lives, and it has changed to incorporate the dimension of environmental quality as we have learned of the environmental effects of fossil fuel consumption. But the concept of the public interest of central generation and low prices that is fossilized in regulatory rules does not reflect that change. I argue that the “Rube Goldberg” machine accretion of RPS, tax credits, and energy efficiency mandates to regulated utilities reflects just how poorly situated the traditional regulated environment is to adapting to the largely unforeseeable changes arising from the combination of dynamic economic and environmental considerations. Traditional regulation is not flexible enough to be adaptive.

The other entrenchment that we observe with regulation is the entrenchment of interests. Even if regulation was initiated as a mechanism for protecting consumer interests, in the administrative and legal process it creates entrenched interests in maintaining the legal and technological status quo. What we learn from public choice theory, and what we observe in regulated industries including electricity, is that regulation becomes industry-protecting regulation. Industry-protecting regulation cultivates constituency interests, and those constituency interests generally prefer to thwart innovation and retain entry barriers to restrict interconnection and third-party and consumer experimentation. This political economy dynamic contributes to the stifling of innovation.

As I’ve been thinking through this aloud with you, you’ve probably been thinking “but what about reliability and permissionless innovation – doesn’t the physical nature of our interconnected network necessitate permission to innovate?” In the centralized electro-mechanical T&D network that is more true, and in such an environment regulation provides stability of investments and returns. But again we see the cost of foregone innovation staring us in the face. Digital switches, open interconnection and interoperability standards (that haven’t been compromised by the NSA), and more economical small-scale generation are innovations that make high reliability in a resilient distributed system more possible (for example, a “system of systems” of microgrids and rooftop solar and EVs). Those are the types of conditions that hold in the Internet – digital switches, traffic rules, TCP-IP and other open data protocols — and as long as innovators abide by those physical rules, they can enter, enabling experimentation, trial and error, and learning.

Thus I conclude that for electricity policy to focus on facilitating what is socially beneficial, it should focus on clear, transparent, and just physical rules for the operation of the grid, on reducing entry barriers that prevent producer and consumer experimentation and learning, and on enabling a legal and technological environment in which consumers can use competition and technology to protect themselves.

Saving the elephants and World Wildlife Day

The United Nations has declared March 3 to be World Wildlife Day. It’s a good opportunity to reflect on the problems of wildlife poaching, which, as Ashok Rao wrote recently, is a moral, social, and political problem.

But, as Virginia Postrel pointed out in her then-NYT Economic Scene column in 2000, it’s also an economic problem, a problem of institution-driven misalignment of incentives. The challenge is to have local community-based institutions that create long-run economic incentives to preserve, or even increase, the wildlife population:

Institutional experiments that give local people a financial stake in wildlife have had some striking successes, particularly in Zimbabwe. There, the government in the mid-1980′s began the Communal Areas Program for Indigenous Resources, better known as Campfire. The program gave local districts wildlife-management authority in communal areas outside the national parks. In some cases, the local districts devolved control further, down to groups as small as 200 villagers. …

Under Campfire, the local authorities worked with outside experts to determine, for instance, that the area could maintain a sustainable elephant population by hunting two elephants a year. Residents would then contract with a safari operator and split the fee of around $25,000 an elephant paid by the hunter. In most cases, the villagers also got the meat from the elephant.

But even such innovative economic thinking has its limits. Both neoclassical and institutional conservation models share an underlying assumption: that the government respects the rule of law and the goal of conservation.

Along the same lines, Arancha Gonzalez writes in today’s Wall Street Journal that Legal Trade Can Save Endangered Wildlife:

Giving rural communities the right economic incentives is critical to protecting wildlife. This is difficult in countries with weak governance and high levels of poverty. Trade bans are often undermined by strong incentives to supply the market demand for the animals and the products that can be harvested from them. Bribes and intimidation from poachers and illegal wildlife traders erode such incentives even further.

And, as Doug Bandow observed in The Freeman last week, a legal market for ivory may be the best way to maintain elephant populations, by creating incentives for people to have elephants around:

Some activists appear to believe that it simply is morally wrong to trade in animals, or at least elephants. But markets have been used elsewhere to help save endangered species.

CITES points to a number of examples. Once-endangered vicunas “are managed through captive breeding and non-lethal harvests from wild populations.” In China, “tigers are being farmed with the intention of supplying tiger parts in the future.” Moreover, “The legal trade in crocodiles is one of the success stories in CITES history which shows species recovery as a result of trade.”

Why not elephants too?

The current system formally treats elephants as sacred, thereby leaving them for dead. Markets would treat elephants as commercial, thereby keeping them alive.

Interpreting Google’s purchase of Nest

Were you surprised to hear of Google’s acquisition of Nest? Probably not; nor was I. Google has long been interested in energy monitoring technologies and the effect that access to energy information can have on individual consumption decisions. In 2009 they introduced Power Meter, which was an energy monitoring and visualization tool; I wrote about it a few times, including it on my list of devices for creating intelligence at the edge of the electric power network. Google discontinued it in 2011 (and I think Martin LaMonica is right that its demise showed the difficulty of competition and innovation in residential retail electricity), but it pointed the way toward transactive energy and what we have come to know as the Internet of things.

In his usual trenchant manner, Alexis Madrigal at the Atlantic gets at what I think is the real value opportunity that Google sees in Nest: automation and machine-to-machine communication to carry out our desires. He couches it in terms of robotics:

Nest always thought of itself as a robotics company; the robot is just hidden inside this sleek Appleish case.

Look at who the company brought in as its VP of technology: Yoky Matsuoka, a roboticist and artificial intelligence expert from the University of Washington.

In an interview I did with her in 2012, Matsuoka explained why that made sense. She saw Nest positioned right in a place where it could help machine and human intelligence work together: “The intersection of neuroscience and robotics is about how the human brain learns to do things and how machine learning comes in to augment that.”

I agree that it is an acquisition to expand their capabilities to do distributed sensing and automation. Thus far Nest’s concept of sensing has been behavioral — when do you use your space and how do you use it — and not transactive. Perhaps that can be a next step.

The Economist also writes this week about the acquisition, and compares Google’s acquisitions and evolution to GE’s in the 20th century. The Economist article touches on the three most important aspects of this acquisition: the robotics that Alexis analyzed, the data generated and accessible to Google for advertising purposes, and the design talent at Nest to contribute to the growing interest in the Internet-of-things technologies that make the connected home increasingly feasible and attractive to consumers (and that some of us have been waiting, and waiting, and waiting to see develop):

Packed with sensors and software that can, say, detect that the house is empty and turn down the heating, Nest’s connected thermostats generate plenty of data, which the firm captures. Tony Fadell, Nest’s boss, has often talked about how Nest is well-positioned to profit from “the internet of things”—a world in which all kinds of devices use a combination of software, sensors and wireless connectivity to talk to their owners and one another.

Other big technology firms are also joining the battle to dominate the connected home. This month Samsung announced a new smart-home computing platform that will let people control washing machines, televisions and other devices it makes from a single app. Microsoft, Apple and Amazon were also tipped to take a lead there, but Google was until now seen as something of a laggard. “I don’t think Google realised how fast the internet of things would develop,” says Tim Bajarin of Creative Strategies, a consultancy.

Buying Nest will allow it to leapfrog much of the opposition. It also brings Google some stellar talent. Mr Fadell, who led the team that created the iPod while at Apple, has a knack for breathing new life into stale products. His skills and those of fellow Apple alumni at Nest could be helpful in other Google hardware businesses, such as Motorola Mobility.

Are we finally about to enter a period of energy consumption automation and transactive energy? This acquisition is a step in that direction.

Adapting to technological change: solar power and fire

Here’s an important tradeoff I never really considered until reading this article: rooftop solar panels can be hazardous for firefighters. It’s an interesting example of how wide and varied the adaptations are to innovation. In this case the potential lethal electrocution from the traditional means of venting a roof on a burning building (creating holes in the roof with an axe) has meant that both firefighters and the solar industry have had to think about fire risk and how solar installations change firefighting and the expected cost of a fire. I wonder how many benefit-cost analyses of solar take into account the higher expected cost of a fire, and the logical associated higher fire insurance premium.

Cochrane on ACA’s unravelling: parallels to electricity

John Cochrane’s commentary in last Thursday’s Wall Street Journal, What To Do When Obamacare Unravels, provides a strong and thoughtful analysis of what a free health care market could look like. In his argument he accomplishes two important tasks: he lays out the extent to which the U.S. health care market is not a free market, and he offers some design principles for a set of market rules and regulatory institutions that would enable competition to flourish and improve consumer welfare:

There is an alternative. A much freer market in health care and health insurance can work, can deliver high quality, technically innovative care at much lower cost, and solve the pathologies of the pre-existing system.

The U.S. health-care market is dysfunctional. Obscure prices and $500 Band-Aids are legendary. The reason is simple: Health care and health insurance are strongly protected from competition. There are explicit barriers to entry, for example the laws in many states that require a “certificate of need” before one can build a new hospital. Regulatory compliance costs, approvals, nonprofit status, restrictions on foreign doctors and nurses, limits on medical residencies, and many more barriers keep prices up and competitors out. Hospitals whose main clients are uncompetitive insurers and the government cannot innovate and provide efficient cash service. …

That the rest of the world spends less just shows how dysfunctional our current system is, not how a free market would work.

I encourage you to read his whole argument and think about it in the context of health care, if you haven’t already. But what really struck me while reading it was the relevance of his logic and his general market design principles to electricity. If you, as I did, reread his argument replacing “health care” with “electricity”, you will see parallels.

Long-standing legal entry barriers, erected decades ago as a regulatory corrective against putative market failure, reinforced and perpetuated by the material interests and political power of the groups that have benefited from the regulation (hospitals and insurance companies in health care, regulated utilities in electricity). Beliefs that the market in question is somehow unique, or at least different from other markets because the services in question are considered to be so essential to human well-being and to our living standards. Conviction, especially among policy makers, that the main way to meet the “public interest” is through control rather than choice, and that as political elites they are the right people to make decisions on behalf of those individual consumers whom they have deprived of making their own choices. These parallels mean that much of Cochrane’s critique is as relevant to electricity as it is to health care.

A final parallel makes this point obvious: the challenge of innovation and technological change to those established interests and their ideas about the public interest and business models in these markets. In both health care and electricity, innovation holds great promise for improving consumer well-being at lower costs, but attempts to create or implement innovation within each industry have been … fraught. In health care new technologies have enabled new treatments, but at a paradoxically high cost due to the lack of competition that Cochrane observes. In electricity new technologies have been concentrated in transmission and distribution operations. In both cases technology’s role and use have resulted from top-down regulatory determinations, not from bottom-up choices based on individual value. Economies of scale and information asymmetries may still make such organic, decentralized choices difficult, but information technology has lessened these asymmetries while other technological changes have reduced economies of scale. In fact, in both industries regulations have reinforced economies of scale that would otherwise have eroded.

Both markets also suffer from the Bastiat problem: the seen benefits of the control approach are much more salient than the unseen benefits of the choice approach in each case. In each case the threat of costly disorder (illness and death, electricity outages) is more salient than the benefits of more individual choice.

Cochrane observes that

Only deregulation can unleash competition. And only disruptive competition, where new businesses drive out old ones, will bring efficiency, lower costs and innovation.

His observation is just as true in electricity as in health care, and in electricity new businesses cannot drive out old ones in most retail markets and many wholesale markets. The sad and pathetic irony is that using the tools of regulatory control to attempt to achieve the desired outcomes of efficiency, lower cost, and innovation in each case will in fact achieve the opposite, by slowing down or stifling innovation and learning-by-doing on the part of consumers as well as producers.

Market processes and liberalization face significant political headwinds in both cases:

While economically straightforward, liberalization is always politically hard. Innovation and cost reduction require new businesses to displace familiar, well-connected incumbents. Protected businesses spawn “good jobs” for protected workers, dues for their unions, easy lives for their managers, political support for their regulators and politicians, and cushy jobs for health-policy wonks. Protection from competition allows private insurance to cross-subsidize Medicare, Medicaid, and emergency rooms.

But it can happen. The first step is, the American public must understand that there is an alternative. Stand up and demand it.

As we look forward into 2014 while reflecting on the experience of 2013, the failure of control, regulation, and political processes to achieve their stated objectives is increasingly palpable for more and more people. Control and politics cannot achieve these objectives, in either health care or electricity.