Energy Policy 1994 22 (10) 811-818 

'Normal' markets, market 

imperfections and energy 

efficiency 

Alan H Sanstad and Richard B Howarth 

The conventional distinction between 'economic' and 

'engineering' approaches to energy analysis obscures 

key methodological issues concerning the measurement 

of the costs and benefits of policies to promote the adoption of energy-efficient technologies. The engineering 

approach is in fact based upon firm economic foundations: the principle of lifecycle cost minimization that 

arises directly from the theory of rational investment. 

Thus, evidence that so-called 'market barriers' impede 

the adoption of cost-effective energy-efficient technologies implies the existence of market failures as defined 

in the context of microeconomic theory. Problems of 

imperfect information and bounded rationality on the 

part of consumers, for example, may lead real worm 

outcomes to deviate from the dictates of efficient 

resource allocation. A widely hem contrary view, that 

the engineering view lacks economic justification, is 

based on the fallacy that markets are 'normally' efficient. 

Keywords: Energy efficiency; Economic analysis; Market imperfections 

At the heart of current disputes over the formulation of 

energy and environmental policy are questions regarding the relation between energy efficiency and economic 

efficiency. In particular, there is continued disagreement 

over the degree to which markets for various energy services as currently structured produce economically 

efficient outcomes, and the extent to which potential 

interventions in these markets would promote economic 

efficiency. These and related issues are critically important in formulating policy responses to global climate 

change: the cost of greenhouse gas emissions abatement 

Alan H Sanstad is with the Energy Analysis Program, Energy 

and Environment Division Building 90, Room 4000, 

Lawrence Berkeley Laboratory, 1 Cyclotron Rd, Berkeley, 

CA 94720, USA; Richard Howarth is with the Environmental 

Studies Program, University of California, Santa Cruz, CA 

95064, USA. 

may hinge in large part upon the efficacy of policies that 

seek to promote increased energy efficiency with little 

or no reduction in energy services. 

This debate is often framed as a dispute between 

engineering and economic approaches to the issues. This 

view, however, is generally misleading. The technology 

oriented approach to energy policy is based on the leastcost provision of energy services and the potential 

economic benefits available through technological 

improvements in energy efficiency. This is, in fact, 

fundamentally an economic perspective, and is appropriately analyzed using economic tools. To the extent 

that this view entails the promotion of policy interventions in energy related markets, it must include an 

account of why economic efficiency in this context is 

not achieved through normal market processes. 

Alternatively, or in addition, proponents of this view 

must explain why conventional economic reasoning is 

inadequate to this task. Such analyses are logically prior 

to the study of how particular policies should be 

designed and implemented. 

Technology analysts have long argued that certain 

market barriers prevent both privately and socially efficient levels of energy efficiency from being realized in 

the economy. With few exceptions, however, the concept of market barriers has not been developed in terms 

of well established economic concepts or using standard 

economic techniques. This has opened the way for skeptics to argue that, in fact, there is at best a tangential 

relation between market barriers and market imperfections as the latter are defined in economic theory; this 

view is expressed, for example, in the writings of 

Sutherland.l A central theme raised by Sutherland is that 

the putative barriers are actually 'normal' market characteristics and thus categorically cannot result in 

economic inefficiency. More specifically, a careful reading of these skeptical analyses reveals that they tend to 

be based on a simple underlying proposition: 'normal' 

markets are efficient. The conclusions are that, with a 

few narrow exceptions, the market barriers concept is 

inappropriate for energy policy and that there is little 

0301-4215/94/10 0811-08 © 1994 Butterworth-Heinemann Ltd 811 
Market imperfections and energy efficiency: A H Sanstad and R B Howarth 

reason to believe that markets for energy services are 

economically inefficient. 

In this paper, we aim to define a middle ground in this 

debate. While accepting the importance of economic 

analysis for studying problems of energy efficiency, we 

will argue that the more extreme variants of the skeptical view are based on an understanding of 

microeconomic theory that is inconsistent with recent 

theoretical developments - especially in the emerging 

field of information economics. We will argue that the 

equation of normal and efficient markets is a fallacy that 

can only serve to distort energy policy analysis. We will 

show that, in light of contemporary theory, the intuitions 

expressed by the market barriers concept may in fact be 

closer to the theoretical mainstream than the views of 

the skeptics. 

Although we will discuss policy issues in general 

terms, it is important to emphasize that we will not seek 

to provide a blanket justification for particular policies 

related to energy efficiency. These must naturally be 

assessed on a detailed, case by case basis. In our view, 

such case specific analysis has been impeded by the a 

priori character of the debate. For whatever reason, an 

unfortunate tendency to argue over putative evidence 

obscures fundamental disagreements over theory and 

methodology. 

The outline of the paper is as follows. We begin by 

reviewing some basic themes of the technology view of 

energy efficiency and its economic content, and the 

evidence suggesting economic inefficiency arising from 

failures to adopt efficient technology. We go on to discuss the idea of economic efficiency, the basic theory of 

welfare economics, different interpretations of this 

theory in light of basic theoretical progress in microeconomics and common misinterpretations of the theory in 

policy applications. Against this background, we review 

energy related market imperfections and show how normal conditions in these markets may entail different 

degrees of economic inefficiency. We then briefly discuss the problem of efficient technology adoption from 

the point of view of theories of diffusion. We conclude 

with a summary of our main theme, and some thoughts 

regarding the importance of research on the relation 

between energy and economic efficiency. 

On energy efficiency 

It is the most commonplace of observations that people 

do not demand energy per se, but rather the services it 

can provide; we do not consume electricity or gas 

directly, but rather heating and cooling, refrigeration, 

lighting and a host of other services. The fact that 

energy is a derived demand has important consequences 

for energy economics and policy. As an empirical fact, 

technological progress yields continued reductions in 

the energy input required to produce energy services. In 

the industrial sector, for example, energy productivity 

improved rapidly even during periods such as the 1950s 

and 1960s, when energy prices were low and stable. 2 

More generally, Hogan and Jorgenson 3 estimated that 

technological change would cause the US energy/GNP 

ratio to fall by 0.34% per year given constant relative 

prices. 

Given the continued development of new technologies, energy services may be produced using a range of 

possible technologies at any point in time. The cost of 

providing or consuming those services, all else being 

equal, falls with technological advance, and there are 

thus higher and lower cost ways of obtaining various 

energy services. That consumers and firms should 

choose the least cost means of obtaining energy services 

is a basic prediction of economic theory: cost minimization is a necessary condition for profit and utility 

maximization. 4 

Over the last two decades, a large body of research 

has established that the observed behavior of consumers 

and firms is apparently inconsistent with the cost minimization hypothesis. In many cases, agents pass up 

least-cost technologies in favor of more energy-intensive alternatives. Although there is considerable 

variation in the methods used in this research, the typical approach is based on iifecycle cost analysis, a 

method firmly rooted in economic principles. A recent 

authoritative survey of these findings was presented by 

the National Academy of Sciences, 5 and found that a 

20-50% reduction of electricity use in buildings could 

be achieved through implementation of cost-effective 

energy-efficient technologies. In the industrial sector, 

investments directed solely at manufacturing processes 

could result in electricity savings of 25-30%, while 

increased use of cogeneration and other measures to 

increase fuel-use efficiency in industrial plants could 

achieve overall energy savings of 30--35%. 

Such aggregate findings are supported by numerous 

case studies focused on energy-efficiency investments in 

households and firms. 6 Meier and Whittier, 7 for 

example, found that consumers rejected incremental 

efficiency investments in refrigerators offering rates of 

return of 40% or higher. And a study of efficiency decisions in firms found that even energy-efficiency 

investments with favorable cost-benefit characteristics 

were not undertaken. 8 

Critics of the idea that consumers and firms apparently do not minimize the cost of obtaining energy 

services have responded in several ways. The counterargument with which we are most concerned here is 

quite simple: with a few minor exceptions, the explanations of the so-called 'efficiency gap' offered by energy 

812 Energy Policy 1994 Volume 22 Number I0 
analysts do not make economic sense, so this phenomenon cannot be significant for energy policy. Note that 

this argument is categorical: it attempts to simply rule 

out concern over levels of energy efficiency by a priori 

appeal to economic principles. To evaluate this perspective, we begin by reviewing the basic first principles of 

welfare economics on which it is putatively based. 

On economic efficiency and its policy 

implications 

The concept of economic efficiency is an elaboration of 

the great insight of Adam Smith that the actions of individuals acting in a decentralized market setting can lead 

to results that are collectively beneficial. The main 

results, known as the first and second theorems of welfare economics, can be described briefly and informally 

as follows. Suppose that resources are allocated by competitive markets where individuals and firms maximize 

utility and profits given preferences and the prevailing 

state of technology. A 'competitive equilibrium' is a set 

of prices and quantities solving all the maximization 

problems simultaneously so that supply and demand are 

equated for each good. A resource allocation is 'efficient' or 'Pareto optimal' if there is no feasible 

alternative that improves the welfare of one or more persons while leaving none worse off. The first theorem 

then states that, under idealized conditions, every competitive equilibrium is Pareto optimal, while the second 

theorem states that, under ideal conditions, every Pareto 

optimum can be supported as a competitive equilibrium 

given some distribution of income among individuals. 

This framework provides a benchmark for thinking 

about economic organization and the merits of the price 

system. To many, it presents an abstract picture of economic activity that is thought to be consonant with 

Western political traditions. This model, however, 

abstracts substantially from the realities of real world 

economic systems, a disparity rooted in the list of idealized conditions required to ensure efficient outcomes, 

including: 

• Agents must hold rational expectations regarding 

prices and product characteristics, that is, a common 

set of probabilistic beliefs based on rational assessment of information held by all agents ('perfect 

information' is a special case); 

• markets must be free from externalities and public 

goods; 

• production must be carried out by firms using technologies characterized by constant or decreasing 

returns to scale; 

• a complete set of markets must exist for all present 

and future goods. 

Market imperfections and energy efficiency: A H Sanstad and R B Howarth 

The violation of any of these conditions constitutes a 

market failure or market imperfection - a circumstance 

where competitive resource allocation will not yield 

efficient outcomes in the absence of policy intervention. 

It is not a deep insight to observe that, relative to the 

theoretical ideal, these market failures are common if 

not pervasive in the real world. As Roberts notes in the 

New Palgrave Dictionary of Economics, 

as the idea of perfect competition has been made more precise 

and the conditions supporting it have become better understood, it has become completely evident that no important 

market fully satisfies the conditions of perfect competition and 

that most would not appear even to come close? 

If the mere existence of market failures implied a role 

for policy intervention, the role for government would 

be expansive indeed. More generally, the costs of intervention must be weighed against the benefits, and the 

achievement of a first best (ie efficient) outcome may be 

institutionally infeasible. 

Opponents of government intervention to correct market failures sometimes argue that problems related to 

transaction costs and imperfect information are 'normal' 

features of economic life that impose natural frictions in 

economic affairs. Ostensibly, this normalcy obviates the 

need for policy action. From both a theoretical and a 

practical perspective, this argument is unconvincing. 

Transaction costs and informational problems are indeed 

pervasive, that is, normal. These factors, however, can 

have major implications for the achievement of efficiency through the market mechanism. Externalities, for 

example, constitute a challenge to public policy precisely because transactions costs prevent market 

participants from negotiating efficient outcomes. 10 

More generally, the view that the system of private 

enterprise produces optimal outcomes as a rule is very 

imperfectly supported by the theorems of welfare economics, a point made compellingly by Nelson. ~l 

Instead, this view follows most naturally not from economic principles but rather from libertarian political 

theory. Accordingly, the most conservative 'economic' 

case against the existence of substantial market imperfections relating to energy efficiency can be seen as 

primarily political in origin. 

Market imperfections related to energy 

efficiency 

Engineering and behavioral studies provide prima facie 

evidence against the hypothesis that markets for energy 

services are free from imperfections. With this in mind, 

we turn to a discussion of key market imperfections that 

may provide explanations for the 'energy-efficiency 

gap'. Recognition of these imperfections is useful in 

Energy Policy 1994 Volume 22 Number 10 813 
Market imperfections and energy efficiency: A H Sanstad and R B Howarth 

interpreting the empirical evidence, guiding further 

research, and ultimately in policy formulation. 

print' of performance labels may fail to imbue consumers with a clear understanding of the choices they face. 

The existing regulatol~v environment 

It is widely recognized that existing pricing distortions 

impede socially efficient investments in energy efficiency. Average cost pricing in the electric power sector 

and uninternalized social costs are two key flaws. 

Accordingly, there is widespread support among both 

technology analysts and energy economists for moving 

toward more rational pricing policies. 

Proper pricing is necessary to equate the private and 

social costs of individual behavior so that agents bear 

the full cost of their actions. Evaluating the empirical 

magnitude of environmental externalities, however, is a 

complex, often intractable problem. Simply knowing 

that prices 'should go up' to reflect these costs is an 

imprecise guide to policy. 12 Moreover, Pareto efficient 

resource allocation requires that agents are able to 

respond effectively to the price signals they observe. If 

institutional failures bar such a response, non-price regulatory policies may be required to restore economic 

efficiency. 13 A further complication is that marginal cost 

pricing may not be optimal in the presence of imperfect 

information. 14 

Imperfect information 

A large body of research has documented that consumers are often poorly informed about market conditions, 

technology characteristics and the impacts of their own 

behavior as they relate to household energy use.15 As a 

result, programs - such as labeling - aimed at providing 

information to consumers have long been promoted by 

policy makers, technology analysts and economists. In 

general, however, such programs have a rather limited 

effect unless combined with more aggressive interventions, j6 A study of appliance labels in Canada, for 

example, found that labels have ambiguous effects on 

consumers' subjective beliefs concerning the choices 

they face. Similarly, Kempton et a117 found that consumers' estimates of the price they paid per kilowatt 

hour of electricity varied from the actual price by up to 

an order of magnitude. It is not surprising that labels 

may not be particularly informative if consumers' informational background is so limited. 

At a more general level, the mere presentation of factual information that is technically accurate may be 

insufficient to induce consumers to make substantively 

rational decisions in the sense discussed by Simon. 18 

Cognitive processes - both the interpretation of factual 

information and the use of that information in decision 

making - need to be taken into account, and the 'fine 

Asymmetric information 

A special form of the imperfect information problem 

arises when parties to a transaction have access to different levels of information. Over the last several 

decades, the theoretical literature has explored various 

aspects of this problem. A central theme is that asymmetric information is extremely common in real world 

markets so that inefficient outcomes may be the rule 

rather than the exception. 19 

In the context of energy demand, producers of 

energy-efficient equipment will in general be much better informed about the characteristics and performance 

of equipment than prospective buyers. Consumers may 

have great difficulty in evaluating the post-purchase performance of equipment prior to sale, forming 'fuzzy' or 

'noisy' estimates based on observable product characteristics. If improving the information held by consumers 

is difficult or costly, the problem of adverse selection 

may arise: given competitive markets, producers may be 

unable to market clearly desirable technologies since 

consumers are unable to observe their superior characteristics prior to sale. z° 

Consider, for example, decisions relating to the 

energy efficiency of new homes. Decisions about heating, ventilation and cooling systems are typically made 

directly by builders rather than occupants. The observed 

failure to implement certain cost-effective energyefficient technologies may result from the costliness of 

overcoming information asymmetries between builders 

and potential buyers rather than a supposed preference 

for inefficient equipment. 21 

A similar problem may inhibit the adoption of 

energy-efficient technologies in existing homes, zz If a 

home owner anticipates selling her home before the economic returns on an efficiency investment are fully 

realized, she will ignore returns that occur after the 

expected date of sale if prospective buyers are unable to 

recognize the potential energy savings and account for 

them when making price offers. 

The 'split incentives' problem that arises in the rental 

housing market may also be understood using the concept of asymmetric information. In the typical case, 

landlords are unwilling to retrofit rental units because 

the resulting energy savings would be realized by tenants who pay the utility bills. Landlords are unwilling to 

pay for utilities since this would create an incentive for 

renters to overconsume energy services. Tenants are 

unwilling to retrofit since they may move out before the 

cost savings are fully realized. In the absence of transaction costs, landlords and tenants would presumably enter 

814 Energy Policy 1994 Volume 22 Number 10 
into contracts to share the costs and benefits of energy 

efficiency. But structuring efficient contracts is by no 

means a simple task, and the net gains achievable 

through improved energy efficiency might be swamped 

by the associated transaction costs. 

Asymmetric information problems may also account 

for less than optimal investments in energy efficiency on 

the part of firms. In an important paper, DeCanio 23 

shows how principal-agent problems between stockholders and managers or different levels of management 

could prevent profitable energy-efficiency investments 

from being undertaken. When managers cannot perfectly observe the behavior of employees, they may be 

unable to reward actions that would, all else equal, serve 

to increase the firm's profits. Accordingly, firms may 

deviate from the idealized norms of profit maximization, 

engaging in second best practices such as capital rationing that discriminate against investments in energy 

efficiency. 24 

Transaction costs 

Problems of imperfect and asymmetric information may 

be viewed from the perspective of transaction cost analysis: the economic gains available from increased 

energy efficiency may be outweighed by costs in gathering, assessing and applying information on the 

characteristics and performance of energy using equipment, installing such measures as thermal shell 

improvements, making decisions about energy efficiency and energy utilization, or reaching and enforcing 

agreements among interested parties. The analysis of 

such costs is frequently confused in the debate over 

'hidden costs' associated with energy-efficiency 

improvements. The latter refer to the indivisible private 

costs associated with such improvements, such as the 

'hassle' associated with installing such measures as 

home insulation. Such hidden costs are, however, only a 

subset of the costs arising in undertaking efficiency 

investments, and many examples exist in which consumers and firms fail to undertake such investments even 

though these private costs appear to be minimal. 2s 

More generally, the problem of analyzing transaction 

costs associated with energy efficiency is in the first 

instance conceptual rather than empirical. Taken at face 

value, the argument that incorporating these costs in 

engineering-economic estimates of savings available 

from increased energy efficiency would cause these savings to 'disappear' is tautologous. These costs are 

indeed 'real' and must be considered in the design of 

policies. However, the argument that such costs are 

'normal' and thus have no implications for economic 

efficiency is a fallacy. The important question for policy 

purposes is whether there are possible interventions or 

Market imperfections and energy efficiency: A H Sanstad and R B Howarth 

alternative institutional arrangements by means of which 

such costs can be overcome when they are present. 

The literature on environmental externalities is 

instructive on this point. In the absence of transaction 

costs, polluters and their victims would negotiate an 

efficient balance between the costs and benefits of pollution without any need for policy interventionfl 6 In 

reality, however, the costs of contract negotiation and 

enforcement - indeed, the very nature of torts law - precludes the achievement of this stylized outcome. The 

existence of transaction costs, rather than rationalizing 

externalities as a 'normal' outcome of competitive markets, provides an explanation for why government 

should intervene to reduce pollution when the benefits 

of such action exceed administrative costs. 

Imperfections in capital markets 

The efficient allocation of resources over time by competitive markets requires that individuals have uniform 

access to capital markets at common rates of interest. 

Under these conditions, interest rates constitute an 

appropriate measure of marginal time preference, or the 

rate at which individuals would willingly trade between 

present and future consumption. 

In practice, imperfections in capital markets are a 

common feature of economic reality that may impede 

certain investments in energy efficiency. Low-income 

households, for example, frequently must pay substantial premia to obtain loans from lending institutions; 

indeed, they may be unable to obtain credit at any price. 

Under these conditions, the poor might rationally use 

high discount rates in evaluating the merits of energyefficiency improvements. But the resulting resource 

allocation would fail to satisfy the requirements of economic efficiency: the supply of all goods and services 

could be increased by reallocating investment to take 

advantage of the high returns available on energy-efficiency measures in low-income households, 

Bounded rationality in energy decisions 

Most types of market imperfection, such as those we 

have just discussed, have to do with problems in the 

economic environment that impede economic efficiency 

even with fully rational agents, that is, utility maximizing consumers and profit maximizing firms. In the case 

of energy related decisions, this hypothesis formally 

requires individuals and firms to solve what may be 

extremely complex optimization problems in order to 

obtain the least cost provision of energy services. 2v 

While it is plausible that the appropriate technical expertise would be available within firms (subject to the 

caveats raised above), it is much less obvious that 

Energy Policy 1994 Volurne 22 Number I0 815 
Market imperfections and energy efficiency: A H Sanstad and R B Howarth 

individual consumers can correctly solve these problems 

when rendering routine decisions. As a result, it is 

natural to consider the consequences of 'bounded rationality' for energy related decisions ie the possibility that 

consumer decisions differ systematically from the conventions of formal optimization theory. 

In comparison with standard theory, this idea might 

be expressed as saying that, while consumers often lack 

complete information about the energy decisions they 

must make, they more importantly lack expertise in processing and applying the information that is available to 

them. Alternatively, if the costs of an ex post optimal 

decision exceed the expected benefits, it might be 'rational' to base decisions on simple rules of thumb that are 

imprecise yet cognitively efficient. 

This hypothesis finds extensive support in the behavioral literature on energy demand. Close study of the 

procedures actually used by consumers in making 

energy-related decisions has revealed systematic deviations from rational or cost minimizing behavior even 

when consumers are motivated to make careful decisions. 28 Other studies have shown the complexities of 

consumers' processing of information relating to 

energy. 29 Even when consumers are given technically 

accurate information through appliance labels and 

related instruments, it is far from clear that they absorb 

and apply it in a 'rational' manner. 

In the context of the demand for energy services, the 

problem of consumer rationality constitutes a legitimate 

'barrier' that is not easily fitted into conventional economic categories. Here, the analogy to the 'normal 

markets' fallacy is the idea that however consumers 

actually make energy related decisions; their choices 

merely 'reveal their preferences' so that no anomalies in 

decision making can be present. In the presence of consumers' documented failure to adopt certain 

cost-effective energy-efficient technologies, however, 

this amounts simply to a tautology: whatever consumers 

are doing, it must be optimal or they would not have 

done it. 

Indeed, research on consumer decision making and 

energy demand raises theoretical and practical problems 

at the frontiers of current research, having to do in particular with the relations between economic models of 

behavior and those of other social sciences. One perspective on these problems is that economic concepts 

are in principle insufficient for analyzing and understanding consumers' energy related behavior. 3° Several 

researchers, however, have shown how bounded rationality in energy use can, up to a point, be modeled using 

the standard tools of optimization theory. 3~ While 

research of this type is still at an early stage, it may provide a bridge between the economic and the behavioral 

perspectives. It is important to note that results obtained 

thus far do show that problems related to consumer 

rationality in energy demand have implications for the 

design of policy. 

The diffusion perspective 

Although more widely applied, the basic framework of 

welfare economics is best suited to static or comparative 

static analysis of equilibrium states. However, problems 

associated with energy efficiency are intrinsically 

dynamic, and therefore naturally analyzed using the 

more specialized theory of technological change. The 

standard economic treatment here distinguishes three 

phases: invention, innovation and diffusion. 32 In this 

framework, the apparent failure of many consumers and 

firms to minimize their costs of obtaining energy services is naturally viewed as a phenomenon related to 

diffusion of technological innovation that is already 

developed. That technological innovations in general 

take time to work their way into widespread use is certainly among the most 'normal' of economic processes. 

Here again, however, the conflation of 'normal' and 

'efficient' markets constitutes a logical fallacy with 

important implications for public policy. Efficiency is a 

property of market equilibria. Broadly speaking, however, technological advance is intrinsically a dynamic, 

disequilibrium phenomenon: the appearance of a new 

technology creates a situation in which at least some 

firms and consumers have an opportunity to increase 

their profits or welfare through adoption, and the adjustment process is a complicated one occurring in real 

time. The standard equilibrium theory serves to 

describe, in a sense, the outcome of this adjustment, but 

not the dynamic process itself. 33 This is not to say that 

diffusion processes are intrinsically 'imperfect' but 

rather that the economic analysis of these processes cuts 

across usual distinctions between efficient and imperfect 

outcomes, and does not provide a unified picture of diffusion processes. 

This complexity is reflected in the various models that 

are applied in studying diffusion. There is no single 

theory of diffusion but instead a collection of 

approaches, each emphasizing different features of the 

process. One standard approach 34 is derived from epidemiology, and in a sense has very little economic 

content. Other models seek to demonstrate how gradual 

diffusion can result from rational decision making on 

the part of individual agents. 35 These so-called equilibrium models of diffusion are based, however, on the 

assumption that all agents are well informed about the 

given technical innovation to begin with, which would 

appear to severely oversimplify the dynamics of the 

process. Yet another approach elaborates the role that 

externalities play in promoting diffusion, and is particu816 Energy Policy 1994 Volume 22 Number I 0 
larly illuminating in that it shows how putative imperfections in the market may in fact be the driving force 

behind diffusion. 36 

Although interest seems to be increasing in applications of diffusion modeling to energy technology, 

surprisingly little work has been done along these lines. 

One recent and noteworthy effort is that of Jaffe and 

Stavins, 37 who attempt to devise a balanced approach 

incorporating both market imperfections and 'normal' 

factors related to the gradual diffusion of energyefficient technology. Howarth and Andersson 38 show 

how, in the context of a diffusion model with consumer 

uncertainty regarding the characteristics of new technology, rational consumers may be slow to adopt 

energy-efficient technologies that would yield them ex 

post benefits. 

Conclusions 

The notion that full-cost pricing is the preferred 

approach to energy policy and that non-price regulatory 

interventions necessarily impose institutional distortions 

is a familiar theme in energy economics. This view is 

based on the rebuttable presumption that markets are 

efficiently structured so that individuals and firms are 

able to respond effectively to the prices they face. 

Without denying the general notion of rationality or the 

well known virtues of competitive resource allocation, 

we may relax the assumptions that individuals and firms 

are perfectly informed agents who are able to solve 

complex optimization problems when rendering routine 

decisions concerning energy efficiency and related matters. Given existing limitations on the cognitive 

capacities of human beings, transaction costs may prevent market participants from negotiating perfectly 

efficient outcomes in the absence of regulatory intervention. In such a world, first-best policy may require the 

joint implementation of pricing and non-price regulatory 

policies. 39 

In this paper, we argue that recent developments in 

microeconomic theory - in particular, the economics of 

information - suggest that many of the 'market barriers' 

to energy efficiency discussed in the literature may be 

understood as market failures properly construed. This 

claim is supported by empirical results that offer prima 

facie evidence against the proposition that markets for 

energy and energy using equipment are free from structural imperfections. It is also broadly consistent with 

behavioral studies of decisions relating to energy and 

energy-efficient technologies. 

With this in mind, we conclude that the debate 

between 'engineering' and 'economic' approaches to 

energy efficiency in fact involves an underlying conflict 

over economic principles. To resolve this conflict, techMarket impelfections and energy efficiency: A H Sanstad and R B Howarth 

nology analysts must acknowledge that empirical findings are meaningful only when linked to a well 

articulated theoretical framework. Similarly, economists 

must recognize that theoretical assertions are meaningful only if they stand up to empirical scrutiny. 

The practical application of this approach involves 

considerations that extend well beyond the limits of 

this analysis. As we noted above, particular policies 

must be judged on a case by case basis, and the mere 

existence of a market failure does not imply that 

government intervention can improve the efficiency of 

resource allocation. As one example, McMahon et al 4° 

estimated that the US appliance efficiency standards 

will save 24 EJ of primary energy between 1990 and 

2015, yielding net economic benefits of US$46 billion 

in present value terms. Those numbers are large by any 

measure, providing ample indication of the practical 

importance of this intellectually engaging problem. 

The authors would like to thank Lee Schipper. Hill Huntington, Jon 

Koomey, Steve Stoft and Richard Sonnenblick for comments. This 

work was supported by the US Environmental Protection Agency 

under contract to the US Department of Energy, Contract No. DEAC03-76SF00098. 

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Energy Policy 1994 Volume 22 Number 10 817 
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818 Energy Policy 1994 Volume 22 Number 10