Suppose you are choosing between two light bulbs.

  • The first is the energy efficient forever light bulb, which lasts forever, costs $52, and uses $2 of electricity per year.
  • The second is a traditional light bulb, which costs $2 dollars, lasts 1 year, and uses $4 in electricity per year.

Which light bulb would you choose?

The economics of this problem is a fairly straightforward if these numbers are going to stay the same going forward. If you buy the energy efficient forever bulb you are effectively making a $50 investment relative to the investment in an old fashioned light bulb (your upfront cost is $52 rather than $2) and each year you save $4, a $2 reduction in electricity costs and the $2 cost of replacing the bulb. You can thus say that your $50 investment in the more expensive forever bulb generates an 8% return, which is pretty decent.

But technology does not stand still and newer forever light bulbs are likely to become more energy efficient and cheaper over time. To make this simple let’s ignore the improvement in energy efficiency and suppose that, because of anticipated improvements in the technology and the manufacturing process, the forever light bulb is expected to cost only $49 next year.

What are the early adopters getting in benefit from their decisions? What are the late majority?

What are the early adopters getting in benefit from their decisions? What are the late majority?

Given the possibility of technical improvements, the economics of the light bulb choice changes considerably. We now must compare the choice of buying a forever light bulb today with the choice of buying the traditional light bulb today and buying the forever bulb in one year. As we show below, the rate of return on buying the forever bulb today (early adoption) relative to this wait-and-buy-later alternative is considerably less than the 8% return we described above.

  • With the forever bulb we pay $52 today for the bulb and $2 for the electricity over the next year.
  • With the second alternative, we pay $2 for the traditional bulb, $4 for electricity over the next year and $49 for the new forever bulb at the end of one year.

The second alternative costs a dollar more over the year; however, it requires $50 less upfront. In other words, the $50 incremental investment in the forever bulb yields a return of only 2%, which is not particularly impressive. Faced with these two alternatives, the consumer should probably wait.

Now if the light bulb technology was simply going to improve on its own, this wouldn’t cause a problem. It would make sense for us all to wait until the improvement in forever bulbs was sufficiently far along before we changed to the new technology. The fact that we are in some sense wasting electricity using inefficient traditional bulbs for another year is more than offset by the fact that in the future we will be using more efficiently produced forever bulbs.

However, we do have a problem if the technology for improving forever bulbs requires that they actually be produced and used. In an earlier post (Why do we subsidize green energy?) I listed this as the 5th reason to subsidize green energy. The idea is that while it makes economic sense to wait for improvements in technology, if we all wait for the perfect forever bulb, the forever bulb doesn’t get produced and the technology never improves .

The early adopters of forever bulbs are providing an important service–they are finding flaws in the product and giving the manufacturers the experience needed to improve the manufacturing process. So, it does make sense to provide them with a subsidy to induce them to provide this service. However, it is important to understand that the subsidy on the new technology, to be effective, needs to be viewed as temporary. If, we attach a $5 tax credit to the forever bulb for the next two years it won’t help. In the above example, the consumer will still rationally wait a year if he can get the cheaper bulb and the tax credit in the second year.

It is also important to understand the effectiveness of subsidizing purchases versus subsidizing research and development (R&D). One would not want to subsidize the purchase of forever bulbs if the early adopter experience effect has only a minor effect on improvements in bulb technology and the real improvements come about from R&D.

If improvements do come about because of R&D rather than manufacturing experience then it might make sense to subsidize R&D and keep the bulbs off the market until the costs are sufficiently low. This is true even when the current economics allow the forever bulbs to compare pretty favorably with the traditional bulbs. Since these bulbs last forever, being slightly better than the status quo is not good enough–we want to wait for them to be considerably better.

  • About Sheridan

    Sheridan Titman, Professor of Finance at the McCombs School of BusinessSheridan Titman is a professor of finance at The University of Texas at Austin and a research associate of the National Bureau of Economic Research. He was recently elected Vice President of the American Finance Association and is incoming President in 2012. He is also the Executive Director of the Energy Management and Innovation Center (EMIC) at The University of Texas at Austin.

    Learn more about Sheridan's research.

    Read about Sheridan on Wikipedia.

  • About this blog

    This blog’s primary focus will be on energy and this will be, more or less, a learning blog. The blog will offer some of my own views, as well as the views of some of the participants at EMIC. I will also raise questions in the hopes of receiving answers, insights and opinions from our participants. Since my own expertise is in finance, much of the initial focus will be on issues that relate to hedging, financing, derivative markets, and the financial evaluation of alternative energy sources. As my knowledge of these issues expand, I would also like to explore issues that relate more broadly to innovation and the role of public financing in this sector.