As global warming continues and our use of fossil fuels must be reduced, we are faced with a change in the way we fuel our choice of transportation’s and provide power to the electric grid.

Consumers need to go from using fossil fuels to the many alternative sources of energy on the market today and in the future. Those being hydrogen fuel cells, electricity (nuclear fission, wind power, wave power, hydropower etc.), renewable carbon-based fuel’s (algae, energy forests, sugar plantations etc.).

As private enterprise change the landscape of available energy sources by the production of these alternative fuel sources, so will consumers adapt to the availability of market alternatives. And here is a thought experiment from an economic perspective, what this situation implies for regular consumers from a standpoint of choice – a choice of energy with implications for the future of the Earth.

Costs, Prices, and Profit

Car companies and energy companies do not follow a preordained agenda, they simply do what all companies (and consumers) do; maximize profits (utility).

As technological development, from basic research at Universities, institutions or private enterprise, is what ultimately drives the development of future available sources of energy. From both a technical standpoint but also from making specific alternative energy sources more attractive from a cost perspective.

And as technology slowly but surely makes alternatives cheaper and more effective this simple aspect creates a powerful virtues circle involving both producers and consumers.

When consumers choose between gasoline and alternative fuels they essentially maximize their utility relative to budget and prices. When prices for alternatives is lowered, consumers will consume more (Ceteris paribus), car makers will react to higher demand by supplying more cars made for use of alternative fuels, and raw fuel companies will change production to increase production of any given alternative.

There is a high degree of creative destruction involved with incumbent oil companies adapting to a new environment, doing research in alternatives, or face market elimination. The logic here is that with an increase in prices for gasoline (oil), one might think that oil companies won’t change production given that more oil still exist to extract, and higher gasoline prices imply increasing revenues. But what is important here to remember is that alternatives will essentially create a new market. A new market is open for entry of firms. And with a decreasing market for oil and an increasing market for alternatives, incumbent oil companies must enter this market to remain competitive or be eliminated.

A consumer level perspective

Meet Bob. Bob is faced with the choice of fueling his car with either x1; gasoline or x2; bio-fuel. Bob’s budget constraint is:

P stands for prices and m his budget.

His preferences (or what economists call ”utility”).

First order conditions.

The marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of utility.

Into.

We get.

The Power of Choice

This proves that Bob will choose the quantity of gasoline or biofuel depending on the price of each relative to his budget. Therefore, the price of environmentally friendly alternative fuels relative to fossil fuels is what ultimately dictates his choice and indeed the future of global warming and climate change.

What Affects Prices?

Subsidizing alternative fuels and taxing fossil fuels, both affect relative prices directly. The major problem and dilemma here is global policy efficiency, the effectiveness of changing relative prices relies on global awareness and many countries agreeing on levels – hence climate meetings such as the United Nations Climate Change Conferences which often prove to be ineffective in real policy change and implementation. Still, countries can affect prices via “green taxes” and subsiding energy from other sources.

But to note here is that continued technological development affects the attractiveness of alternative energy sources and this will ultimately lay the foundation for the road ahead.