“Do Households Understand Electricity Prices?”
Blake Shaffer (University of Calgary)
Economic theory often assumes consumers will respond to marginal price—the cost of one more unit of electricity. Yet empirical evidence suggests consumers may take a simpler approach, responding to average price (Ito, 2014). This paper considers a third alternative, that of households severely misunderstanding nonlinear prices—incorrectly perceiving that the marginal price applies to all consumption, not simply the last unit. Exploiting a natural experiment in British Columbia, I find evidence of this type of behaviour among a subset of households. While small in number, the exaggerated responses by these households have a large effect in aggregate, masking an otherwise predominant response to average price. Previously largely unexplored in the literature, this type of misunderstanding has important economic, policy and methodological implications beyond electricity markets. I estimate the welfare loss for these households to be the equivalent of 10% of annual electricity expenditure.