Rising Gasoline Prices-BECKER

The causes of the sharp increase in gasoline prices during past year and a half are clear. The main ones are the rise in the price of oil to over $70 a barrel, and the lack of unused capacity in oil refineries that makes it difficult to increase gasoline production. Since refineries pollute and are generally unpleasant to have in one's neighborhood (the NIMBY, or Not in My Back Yard, mentality), political opposition prevented any new refineries from being built in the United States since the 1970's. We are reaping the consequences of that opposition. Gasoline prices have risen by about $1 during the past year to almost $3 a gallon. This is a very large increase over a short period of time, but it should be put in perspective. Spending on gasoline by the average household has risen from about 2% of its total consumer spending to a still low 3%-it reached over 41/2% of personal consumption spending in 1981. The real cost of gasoline, adjusted for changes in the price level, is less than in 1981. Since a typical family has a higher real income than it did 25 years ago, the burden of high gas prices is easier to bear now than at that earlier time. The higher price will pinch for families who commute long distances to work in their SUV's, but the price of gasoline does not have a major effect on the many poor families who take public transportation to work. Most of the other economic consequences of higher gas prices are beneficial to a world concerned about an over-dependence on Middle East oil producers. They induce consumers to drive less and to shift toward more fuel-efficient cars. They encourage politicians to worry about why American refineries have not been built for over 30 years, and to remove some of the regulatory obstacles. High oil and gas prices encourage the hunt for additional sources of oil in shale and tar pits, and give researchers greater incentive to search harder for alternatives to the gasoline-powered internal combustion engine, such as electric powered engines, fuel cells, ethanol, and other alternatives. On the other hand, many potential political consequences of high gas prices are worrisome and even scary. As Posner indicates, the proposed $100 rebate to taxpayers would help many well-to-do families, and have a minor effect on families that have been hard hit by the rise in gas prices. Perhaps even worse are the proposals to investigate whether oil companies have conspired to raise gasoline and oil prices. No one mentioned any oil conspiracy when real gasoline and oil prices declined significantly during the 1980's and 1990's. Stagnation in the number of American oil refineries, the havoc caused by Katrina to refineries in the Gulf, rapidly growing world energy demand, and disruptions in the world supply of oil during the past year are sufficient to explain high gas prices without any conspiracy theory. I doubt if "excess" profits tax on oil producers will be introduced, but even the suggestion to do that is disturbing. It is related to, although different from, the oil "windfall" profits tax in effect during most of the 1980's. Profits of oil producers are volatile, and were depressed during the 1980's and '90’' when oil prices fell a lot. Higher profits encourage greater investments in looking for new oil reserves, while governmental restrictions on profits discourage the search for new oil sources that are crucial to controlling oil prices in the longer run. I do believe Congress should roll back the some $2 billion in tax breaks given to oil companies last year. They never should have been given in the first place, but these benefits mainly reflect the political power of the oil industry, a power that is at least temporarily in retreat. One of several better ways to encourage oil production in North America is to open the Northern Alaskan region to oil production; President Bush has proposed that once again. The advisability of raising taxes on gasoline, supported by Posner, is not so clear, even aside from the political impossibility of increasing taxes when gas prices are high. One disadvantage of higher taxes is that they partly offset the incentives provided by high gasoline and oil prices to invest in new sources of oil, such as shale, that reduces dependence on Middle Eastern oil. Federal, state, and local governments of the U.S. combine to impose taxes on gasoline of about 60 cents per gallon. Studies by Resources for the Future suggest that this is more than adequate to cover all effects of pollution, aside perhaps from some larger estimates of the effects of gasoline consumption on greenhouse warming. The purpose of gasoline taxes is to cut consumption by raising gasoline prices to consumers, but the $1 increase in gasoline prices during the past year has cut gas consumption. These higher prices, if they stay, will cut gasoline usage much further as consumers have more time to adjust their behavior. If the optimal tax on gasoline was $1 when gasoline sold for $2, the effective tax is now $1.60: the 60 cents imposed by governments and the $1 increase due to market forces. So, if anything, this argument suggests that gasoline taxes be reduced rather than increased while prices are so high.

Comments

[Joe]

In focusing mostly on supply issues, you failed to adequately address other issues related to the demand for oil. One percent of consumer spending may not sound like a lot to someone with a six-figure income, but it's significant to me. Posner is right to note the short-term inelasticity of gas prices because it can take a great deal of time to adjust one's lifestyle.

You used a phenomenon more closely associated with very local neighborhood politics (NIMBY) to explain why no new refineries have not been built. Other polluting industries have been built over the same period of time and have overcome opposition. I'm not convinced NIMBYism can adequately explain why no new refineries have been built.

I could argue, instead, that what we are reaping is our failure to reduce consumption, rather than our failure to increase domestic supply.

The issue of drilling in a wildlife refuge in Alaska has clearly become a very partisan issue, and you added nothing to the debate. You merely adopted a partisan stance on the issue.

I also doubt that studies conducted by one single D.C. think tank could adequately constitute the most reliable source of information on optimal pricing. The effects of pollution reflect only a single dimension of the social cost of gasoline consumption. Aren't there other dimensions worth considering?

[James]

A few quick points.

First, I don't understand the reasoning about externalities right at the end. The optimal price for consumers will incorporate all social costs of producing and consuming oil. These costs have 2 components: the price and the various externalities (pollution and congestion) that aren't reflected in the price. When prices rise, this does change consumer behavior, but that doesn't make the externalities disappear. We might want the tax to offset the externalities ("internalize" them). When the price rises by a dollar, the optimal tax doesn't change (holding externalities constant). That's why I don't understand this sentence:
"If the optimal tax on gasoline was $1 when gasoline sold for $2, the effective tax is now $1.60: the 60 cents imposed by governments and the $1 increase due to market forces."

My second point, one that I made in Posner's comments as well, is that oil extraction has its own externalities. The Wall Street Journal ran an article on March 27 entitled "As Prices Surge, Oil Giants Turn Sludge Into Gold." It turns out that extracting oil from the oil sands in Canada causes some serious environmental problems.

[Adrian]

You mentioned that the increase in gas prices will not affect lower income people who rely on public transportation. What about the effect of gas prices on public transportation that may force fares to increase and routes to be reduced?

[Joe Merchant]

On one side, are you running for office? Opposing returning $100 to "well to do" families, while pointing out that it's a trivial pittance for the poor? I don't see a problem with blind lady justice sharing the refund across the board - surely $100 makes a larger difference to the poor than the well-to-do.

I do agree that tax breaks for and industry experiencing record-breaking windfall profits are beyond bad - it's not as if we are running a surplus federal budget at the moment. On the other hand, cutting taxes on retail gasoline because the market has driven prices up is nearly the same thing. If the market has driven prices up, meddling with that increase through tax breaks will only prolong the arrival of viable replacements for the high priced commodity. While I love my car, I don't love it enough to see half of Florida underwater. It will take time to replace fossil fuel burning personal transportation, perhaps more time than it takes to make Greenland green again. If the market is making gasoline expensive, taxes should be helping to accelerate the situation, rather than mask it.

[N.E.Hatfield]

As for "NIMBY", let the Asthete's and various Ecologists freeze and starve in the dark. This may be what it takes to get the ball rolling again. Confrontation by survival on the most basic level is a powerful motivator. ;)

[Nita Neets]

I found a great way to save on gas and so will you...

www.ethosfueltest.com

[Corey]

"I doubt if "excess" profits tax on oil producers will be introduced, but even the suggestion to do that is disturbing."

Why? You start your post saying that high prices have benefits in reduced consumption and dependence on the Middle East. You and Posner are perfectly willing to let the market force people to move and stop taking road trips. But then when the question becomes one of taxing oil company profits, the language is all about the "search for new oil sources that are crucial to controlling oil prices in the longer run."

So it is fine for oil companies to gouge consumers because that will reduce our consumptory need for oil, but it is not fine to tax profits because that would reduce our production of oil? (and consumption to the degree the taxes could be passed on) In other words, you want us to have massive stockpiles and new sources of domestically produced oil, but the oil companies can drive up prices because too much oil consumption is bad.

I'm sorry, but to me, giving Exxon the power to simply set oil prices at the maximum the market will bear is functionally identical to "dependence" on Saudi Aramco. I don't get dividends from either company, but I do buy gas.

[Corey]

"As for "NIMBY", let the Asthete's and various Ecologists freeze and starve in the dark."

Hatfield, many environmentalists are prefectly happy living off the land and sleeping when it gets dark, the problem is that there isn't hardly any place left to do that. When the whole world becomes a wasteland and WalMart parking lots are the only thing stopping soil erosion the ecologists will at least remember what nature was like. I guess we will all be sorry then, but for different reasons.

If it is a choice between destroying the ecology (such as it is) in the Arabian desert and destroying Alaska, I say let Aramco build the wells and leave the bears alone.

[N.E.Hatfield]

Corey, There in lies the point. You folks really don't get it. ;)

[Anonymous]

Corey: So it is fine for oil companies to gouge consumers.

And you have evidence of this. Oh, I forgot you were sick the day they taught law at law school.

[Paco]

Dear Professor Becker: I found your discussion of taxes on gasoline consumption to be illuminating. My concern, however, with the gasoline consumption taxes is that motorists in less developed countries, such as Egpyt and Mexico (where the retail price of gasoline is very low), are in effect granted a subsidy to consume gasoline while at the same large consumption taxes are imposed on motorists in developed countries. Efforts to reduce gasoline consumption should be coordinated across int'l borders, but coordination is all but impossible due to the classic free rider problem and the need for political stability in LDC's.

[Belgian]

Let's also look at the opportunities rising oil prices create: companies developing, e.g., less consuming car engines have a fantastic future ahead. Shares prices of such companies (some being still in R&D phase) speak for themselves...

[N.E.Hatfield]

While we're at it, lets take a look at other portions of the "demand equation". How many people realize that for every calorie of food product consumed it takes 10 calories of hydrocarbon product to produce it? This represents a 10% conversion efficiency; which is an abysmal energy conversion efficiency in any Engineering text.

The individuals who figure out how to increase this efficiency are going to walk away wealthy and really put the "green" into the Green Revolution.

[ryan brown]

Most of these are related comments about oil issues--not gasoline per se. Issue #4 is a tirade on executive pay.

Issue #1:
I reject most "increase oil supply" arguements offered by the majors and by several posts as a solution for high oil prices (and reducing prices may not be optimal public policy depending on the magnitude of the pollution/extraction externality).
A couple of months ago, Congress summoned the CEOs of the oil majors together to explain why they were so profitable, and to explain why congress should not levy an excess profits tax. Their defense was essentially "it's not out fault we're so profitable--oil prices emerge from world supply and demand factors and even though we're large firms, we're dwarfed by OPEC & other oil-rich countires." Let's assume they are right.
Since oil is a global commodity, increasing domestic reserves will only slightly impact the world price, yet increase profits of the firms/states that were opened up. I can only imagine who would have access to previous off-limits domestic oil supplies--my guess is not Saudi Aramco.

Isssue #2:
The angriest parties should be shareholders of these firms. It is true that shareholders of oil firms have seen great increases in share price lately, but (as admitted by managers) this has been driven by factors outside of management's control. I as a shareholder want to reward managers only for things they can control--yet I can guarantee that a significant fraction of these managers' salaries (such as the politically charged pay package of Mr Raymond from ExxonMobil) comes from stock options based on the stock of their firms. This (perhaps percieved) injustice can't be good for the oil majors political capital.

Issue #3:
From an economic perspective, an excess profits tax will not have a substantial effect on oil supplies nor on the productivity of the oil majors. If we believe the majors, (see issue #1), then there's not much they can do about world supply anyway. Furthermore, an excess profits tax might paradoxically spur better cash management, because firms with cash windfalls tend to waste excess cash--usually by overinvesting in R&D (see the oft-cited Jensen '86 AER). Finally, if firms really need to get cash to invest, they can sell shares or debt instead of relying on retained earnings.
The excess profits tax is not economically based, it is politically based--people are mad and they want big oil to pay. I'm not in favor of gov't micromanaging other's business--but I think the economic consequences of an excess profits are overblown.

Issue #4.
Does anyone really deserve to be paid 400m? Certainly if you paid me more for expending more effort (sassuming we can link effort with some contractable performance measure), I would work harder--this seems like a no-brainer. But when does this get silly? Should I pay an executive $50k, $1m, $50m or $1b for every dollar increase in share price? Would Mr Raymond have worked as hard if he had "only" made $100m?

[Hans Gruber]

Ryan Brown,

A small change in global supply can have considerable effects, especially when global supply is stretched to its maximum capacity (as it is approaching). Moreoever, anything we can do to inrease our energy independence is a good thing.

And why, pray tell, do you think taxes won't effect supply? What "economic perspective" is that from?

Ryan wrote: "If we believe the majors, (see issue #1), then there's not much they can do about world supply anyway."

This represents a fundamental misunderstanding of economics. When the oil companies say, "we don't control price, we produce as much oil that we can which is economically feasible and the world market sets price." That is not the same as saying, "If prices drastically increase, we will not increase supply." You see, as prices rise the amount of oil which can be profitably extracted and refined increases. You are conflating two different questions; which is at least one reason why your comments are so horribly confused.

As far as your petty whinning about executive pay--give it a rest. Yes, some individuals really are worth that much; though increasing shareholder accountability would undoubtedly improve the situation, in my opinion.

And, yes, of course somebody will work much harder for 400 million than they would for 100 million. Who wouldn't? And I'd worker harder for 1 billion than I would for 400 million, too. Not everybody would, of course, but CEOs of multi-billion dollar corporations are not anybodys. This is not to say that some corporations do not overpay their executives. This is not to say that the incentive structure of executive pay could not be better structured. But, please, relieve yourself of this strange envy which clouds your judgment.

[jim cee]

Regardless of who what you believe on supply/demand, I think everyone could agree that even a small drop in consumption could cause prices to drop.

What I'm going to say will no doubt be met with skepticism and mockery. What I'd love is for someone to challenge what I'm saying to a factual test, where the results can be made public.

Simply, I believe than anyone, driving any kind of vehicle can increase his/her MPG by an average of 10% without any sacrifice what-so-ever. My ideas have been tested, refined, practiced and documented over seven years.

The great majority of people drive to and from work daily in an urban/suburban environment. It includes local residential roads, highways with traffic signals and country roads. It is also possible to improve MPG on limited access highways, but the focus of my program local driving. It requires a complete change of mindset that carries additional benefits such as increased safety and reduced wear on vehicle mechanics. It is in the day to day commutes, where the greatest potential for MPG increases are possible.

I'm talking specifically about increasing the MPG on any type of gasoline powered vehicle. This does not entail walking, bike riding or any other alternative to driving. Nor do I advocate a driving style that would increase time of travel by reducing over all transit time. In fact, my own results have been proven not only on local commutes but on interstates where I obtained greater than published EPA mileage estimates while maintaining an AVERAGE of 72 MPH over a 300 mile round trip. (No, it was not downhill both ways)

I'm not selling anything. No attachments, no snake oil additives, no miracles. I want nothing other than for someone, somewhere to challenge me and help get my message across to the public. This might include a nationwide education program to change the habits of drivers.

There is no detail here as to how my results can an be obtained. It would be useless to put my thoughts in print until someone is seriously interested in knowing the. The best way to convince a skeptic is through first hand experience. Are you that skeptic? Would you put me to a challenge could reduce the consumption of gasoline nationwide by 10%? Can you imagine what a sustained reduction of that size would do to prices?

If anyone posts back, who wants to seriously challenge me, I will respond and provide an email address. If there is anyone who is located close to West Michigan and wants to see first hand, I welcome your interest.

[Dan C]

If a country produces oil and the world demands more oil, how can you avoid making more profits (in a free market)? The world price increased for what you have, all else equal, you make more profit. Would we be better of if we taxed domestic oil firms out of business?

If the world demand for wheat went up, would we scream that farmers should not be allowed to increase their profits? Or would we expect farmers to increase production, with a lag, and find a new equilibrium world price?

While the demand for oil may be more inelastic then wheat wouldn't we still expect the same market forces induce increases oil production (and energy sources in general) until the world finds some price stability?

We are heavy consumers of oil because it is cheaper then alternative fuels. When the scales tip, and consumers consider it a permanent tip, they will quickly switch to alternative fuels. However history tells us that while energy prices spike from time to time, alternative sources have not become viable. One day it will, but we are not there yet.

Government interventions in the markets are distorting and unwelcome. Where would the revenue from higher gas taxes go? Into pet projects of Congress and the White House. Some could feel good that they slapped around the workers and stockholders of oil companies, but they take away the profit motive to find new sources of energy. How can politicians still think that central planning works better then markets?

People often make fun of the Post Office, as a government service that is inefficient, but I think highway road construction is a joke. The per mile expense and the inefficiencies shock me. Never mind the hidden cost because of all the political mandates. The delays, wasted fuel, wasted time, etc is all part of having government construct roads without a profit motive and without answering to the drivers they incontinence.

I will agree that the salaries to oil company executives are out of control. I don't see how you can reward a person who really controlled so little.

To Judge Posner, who tells us to relax and learn to love higher fuel taxes, I disagree

Posner argues high taxes will reduce consumption and lower oil prices. But who gains from the lower oil prices.

Not American consumers of oil. To get the result Judge Posner wants (decreased use of polluting fossil fuels) as world oil prices fall (his assumption) Congress would need to raise taxes again and again to keep oil demand down. Americans may be buying clean air but the price could escalate quickly. What is the optimal level of pollution and will government taxes get us there.

If the world price for oil falls, the only remaining producers will be the lowest cost producers. The countries that Judge Posner tells us to fear are also the lowest cost producers. These difficult countries may make smaller profits, but the domestic oil business could be destroyed.

Countries like China and India may be come even more addicted to the now lower cost oil (because of decreased American demand. They may replace the green house gases that we eliminate. Perhaps worse, they may side against the US in world disputes with their suppliers.

Just let markets work.

[MnZ]

I notice that some posters seem to have a adopted the both of the following two beliefs:

1) Demand for petroleum is very price inelastic.

2) Increased supply for petroleum would not have much of an effect on price.

A quick review of Economics 101 would demonstrate that those positions are contradictory.

[ben]

MnZ

When I draw a (nearly) vertical demand curve, then an upwards-sloping supply curve, then shift it right, I get a significant price reduction. If supply is also inelastic then the price reduction is especially large. Am I missing something?

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