More On Fuel Substitutability And Alternate Fuels

This Rigzone article from Friday does a nice job of summarizing what in economics is known as the substitution and income effects of price increases. In plain English instead of econ-geek-speak, when the price of a (normal) good goes up, all other things equal, the change in its price relative to substitutes for it induces people to shift from consuming the good to consuming its substitute. Also, the price increase decreases your real purchasing power, so part of the reason you decrease your consumption is the feeling of income loss. Thus substitution and income effects. The article’s abstract captures that idea nicely for fossil fuels and alternate fuels:

High oil and gas prices, currently increasing the profits of petroleum producers, may result in more competition down the road as products from alternative fuel developers become more attractive on a cost basis while still carrying a ‘green’ cachet.

The economic content of this simple sentence is fabulous. First, oil and gas prices are currently high for various reasons. Because of income and substitution effects, those high prices encourage consumers to shift to substitutes. In the short run, those substitutes are things like taking public transportation, walking, biking, carpooling, telecommuting, etc. But in the long run, opportunistic suppliers see this as a profit opportunity and invest in the substitutes for oil and gas. That is a market mechanism behind the impetus to invest in alternate fuels. The first sentence of this article puts it right out there:

High oil and gas prices, while pinching the wallets of millions of North American businesses and consumers, are creating opportunities for companies trying to come up with alternative fuels.

Thus the dynamics of innovation. And, of course, as this innovation takes place and its fruits are commercialized, demand shifts away from oil and gas, and prices fall, and capital flows away from oil and gas and into its substitutes, until we reach some kind of equilibrium or something else induces us to either change more quickly toward alternate fuels, or to move back toward oil and gas (such as finding new deposits).