The Gasoline Price Spike: Another Nonissue--Posner

The extraordinary congressional reaction to the recent increase in retail gasoline prices, though distressing to economists, is not surprising. Since the latter part of last year, the average retail gasoline price has risen from slightly over $2 a gallon to $3 a gallon, largely as a result of increases in the price of crude oil. The rapidity of the increase in gasoline prices has made it difficult for many consumers to adjust by altering the amount of their driving; demand tends to be inelastic in the short run. Suppose you drive 10,000 miles a year and have a modest income, say $40,000. You probably buy about 500 gallons of gasoline. If the price per gallon rises by $1 and you are able to reduce the amount you drive by only 10 percent and so buy 450 gallons, your total expenditure on gasoline will rise from $1,000 (500 x $2) to $1,350 (450 x $3), an increase equal to almost 1 percent of your income. For people of modest income, such an increase in expense is palpable. The fact that in inflation-adjusted dollars the price of gasoline is roughly the same as it was in 1949 and much lower than it was in 1982, or that retail gasoline prices are twice as high in the United Kingdom (and several other European countries) as in the United States, is no consolation to these people. Moreover, because people buy gasoline frequently, they are very conscious of changes in its price. And there is so much publicity about oil and so close an identification of the Bush Administration with the oil industry that people are primed to think of gasoline prices as having a special economic and political significance, and to suspect that increases in such prices are a result of malign influences. In fact the cause of the price spike is primarily, as I said, the increase in crude oil prices, and that increase is in turn primarily the result of rapid growth in demand for oil by China (now the world's second-largest consumer of oil) and India, a growth that has outpaced supply. The notion that this represents a crisis--that the world is running out of oil--is ridiculous. In the short run, with demand rising faster than supply, price rises steeply, producing "obscene" profits since roughly the same quantity is being sold at higher prices. In the longer run, consumption falls as consumers search out substitutes; supply rises as previously uneconomical sources of oil become economical; and so profits fall back to a normal level. One of the principal measures being mulled by Congress to respond to the pseudo-crisis--a $100 income-tax rebate to all federal taxpayers even if they don't own cars or other vehicles and have incomes of $150,000 ($219,000 in the case of a couple filing a joint return)--has the virtue of simplicity and, since it does not affect the price of gasoline, will not discourage, at least directly, efforts by consumers to economize, though if people think it signals that the government will help them pay for gasoline, they will have less incentive to reduce the amount of driving or switch to more fuel-efficient cars or to public transportation. As a measure for alleviating hardship, the $100 rebate is absurd because it is at once trivial in amount and not limited to low-income taxpayers. Other proposals being considered by Congress would if adopted reduce the price of gasoline, as by cutting gasoline taxes. Such measures would have worse effects on demand and prices: by increasing demand, they would drive prices back up. But allowing more drilling, which is also proposed, would increase supply, though not immediately. On the demand side, requiring that new vehicles have better gas mileage is similar to hiking gasoline taxes, by making cars more expensive. But the effects are delayed, and it is a measure inferior to a tax because it prescribes one method of adjusting to higher gasoline prices rather than allowing consumers to choose how best to adjust. Many consumers would prefer to drive less (substitute public transportation, telecommute, car-pool, move closer to work, etc.) than to buy a more expensive car that gets better gas mileage. From the broad national standpoint, we should welcome high gasoline prices because it is in the national interest to reduce our consumption of gasoline, and high prices will do that, dramatically so in the long run when more substitution is possible. The burning of gasoline in vehicles creates pollution and emits carbon dioxide that contributes significantly to global warming; and curtailing driving in order to reduce the consumption of gasoline would alleviate traffic congestion. Furthermore, a large part of the world's oil supply comes from nations such as Venezuela, Nigeria, Iraq, Iran, Saudi Arabia, and Russia that are actually or potentially unstable, hostile to the United States, or both, and it would be prudent to reduce our dependence on such suppliers. And in fact output has fallen recently in the first four nations in the list, which has contributed to the price spike. But the best way to keep gasoline prices high may be through heavy taxes, which might actually reduce the cost of oil and hence the incomes of the oil-exporting nations (which is in the U.S. national interest to the extent that those nations are indeed hostile, as Iran notably is). If, by increasing the price of gasoline, taxes reduce consumption, the price of oil will decline because the average cost of oil increases with the quantity produced. Just as an increase in demand will cause higher-cost oil to be produced--oil that would not have been economical to produce when the market price was lower--so a reduction in demand will cause that higher-cost oil to be withdrawn from the market and so the average price of oil will fall. In effect, income of the producing nations will be transferred to the consuming nations in the form of gasoline taxes imposed by those nations. As Becker points out in this comment, higher taxes will dampen the incentive of oil companies to invest in exploring for and developing new sources of oil, since their net revenue from selling oil produced from such sources will be reduced. However, I am unenthusiastic about creating incentives for producing more oil, because of my concern about global warming. (See my book Catastrophe: Risk and Response [Oxford University Press, 2004].) Stiff taxes will put pressure on the energy industry to achieve technological breakthroughs (such as sequestration of carbon dioxide) that will greatly reduce the use of fossil fuels. Unfortunately, a population ignorant of economics and suspicious of the Administration's motives probably cannot be brought to understand the social benefits of high gasoline prices and heavy gasoline taxes.

Comments

[Haris]

BUT, if gas prices are high and the extra money goes to line the pockets of states that support terrorism and double-jowled oil company executives, THEN the public gets upset. And rightfully so.

I wouldn't dare to claim to speak for Judge Posner, but it seems to me that that is the type of public ignorance that he is talking about. The general public hasn't cared about who gets their oil money in the past, since we've been buying Middle Eastern oil to pay the salaries of oil executives for decades. It is only when the public perceives that there is something improper going on, like a pro-oil administration or a corporate oligopoly, that the public gets upset. And perhaps it is true that the current administration has pursued policies that benefit oil companies, but the rise in oil prices is largely due to increased worldwide demand, and to a small extent the situation in Iraq. When the voting public [emphasis on voting] perceives that prices are being manipulated to their detriment, no politician can advance higher gas taxes as a solution because they lack the political capital to do so.

[John Booke]

"For people of modest income, such an increase in expense is palpable." And a very good reason to place a cap on gasoline prices now.

There is no non-biased data regarding global oil "demand." EIA and IAE provide statistics and data that are sourced from commercial energy units. If one still accepts their numbers then look at the weekly storage of crude oil in the US (the world's largest consumer of oil). We have a glut of crude oil.

A very good way to keep energy prices low is to keep Wall Street investment banks away from the physical supply of energy.

[Justin]

You write:

"In the short run, with demand rising faster than supply, price rises steeply, producing "obscene" profits since roughly the same quantity is being sold at higher prices."

But don't oil companies also have to pay higher prices for crude? The way I see it though their overall revenues will surely be higher, profits should not necessarily increase because costs have gone up. Am I missing something?

[Haris]

Yes. We are talking about the crude oil sellers. That's the oil companies we are talking about. They are making more money with high oil prices but the costs of producing it aren't going up in the short term. [In the long run, marginal costs of producing rise, for example when new wells have to be drilled and refineries build.] Intermediaries, like independent gas stations, aren't making any increased profits from the rise in crude oil prices.

[Glen Dunn]

Unlike most commodities, oil (and thus gasoline) are fundamentally necessary for the maintanence of society and national security. Since it seems that Mr. Bush's ties with the major oil companies lobby are thinly veiled, would it be impossible to suggest the nationalization of the oil industry? Is this a redundant suggestion?

If, through legislation, the goverment, in the interest of national security and public welfare, created a public agency that sold oil to the American public and regulated its price, the profits could be curbed to an acceptable level and would be to the benefit of the population as a whole, not just a few wealthy executives. Ultimately, only the voting public carries a stick big enough to trump the oil industries corporatist stanglehold.

This would beg a few fundamental questions, and present some very difficult economic obstacles. Does America benefit by the fact that most of the world's post-refined oil profits flow to American companies? Is there a conflict of interest between the federal goverment and the oil industry, in so much that the relationship between the oil producing nations and the oil refining companies can result in price collusion, which is to the detriment of the American public? Could the U.S. Goverment directly sell oil in foreign lands? Does the scenario I am proposing differ from reality? Do the companies themselves simply act as an intermediary (laundering) of this money, since the world cummunity would not accept the U.S. Goverment in this role. By the way, how much does it cost to fill up an Aircraft carrier (assuming it is not nuclear powered)? Does this relationship benefit the taxpayer or not?

Having grown up overseas in Great Britain, these prices still seem extrodinarily low. I agree that lowered consumption is to the benefit of society and the world, but drastically shifting prices upward, perhaps in the form of sharply raised taxes, without allowing for inflation and providing viable public transportation alternatives results in a catastrophic decrease in discretionary consumer spending. The underlying tenent to "terrorist" philosophy is to attack the strength and growth of our economy, as it is the means by which we impose our will and way of life upon the world. Is your suggestion a self-imposed recession of rather deep proportions in order to force the hand of fuel alternatives and free our society from oil dependance? Is it realistic?

I guess I could have talked about more practical issues, but the "Blog" is a great forum for provoking strong responses.

[Atlas Will Shrug]

You failed to address that the end result of all use of fossil fuels is consumption or production of goods or services.

The price of gasoline is merely a transaction cost to the economic engine. Raising taxes would impair the economy commensurately, at least until a lower cost alternative could be implemented.

If the real goal is reducing the risk of global warming attributable to mom's minivan, why pause at raising gasoline taxes when you could go all the way and ban all use of fossil fuels? Since the economic impact may be assumed away, incrementalism serves only to delay the inevitable retrenchment to oxen-drawn freight wagons.

But wait, your ban on fossil fuels would also encompass oil and coal-fired electrical power plants, which is a poser to the tree-hugger.

But alternatives exist to the open-minded. For decades insurmountable regulations and, dare I say it, federal court appelalte judges, have prevented construction of any nuclear power plant in the U.S. for decades. The consequence is that we are dependent upon fossil fuel power plants, which emit somewhat more green house gasses than mom's minivan. So there you have it, melt down the entire planet and swim in your acid lakes while taxing us into poverty or fire up the economy with a tax cut and low-cost energy with the risk that Homer will spill his Pepsi on the keyboard and melt down a local piece of Arco, Idaho from time to time.

The nuclear-generated electrical power could be used to fuel new, existing nanotechnology batteries, which have increased storage capacity and efficiency, enough for feasible use in vehicles, and soon enough to render obsolete internal combustion engines. That is, assuming access to cheap enough electricity.

As for safety? Every form of power generation poses risks. Technology has advanced somewhat since the disaster in Chernobyl and intervening oil tanker spills. Unless one assumes that technology will cease to advance from this point forward, it is probable that disposal of nuclear waste could be managed. Anyone who asserts there is no place to store waste simply has not driven the Prius west of Chicago. If it must be in my back yard, so be it.

Your notion of taxation to control behavior smacks of Soviet Era economic management. It is ironic that every state, county, and city in the U.S. will offer to reduce taxes and waive regulations to induce business to situate nearby, yet each does not hesitate to impose incrementally higher taxes and regulations for their supposed notion of greater good. Ayn Rand was exactly right.

Your proposal is fundamentally, fatally flawed. Thank goodness the scope of your influence is limited to the Seventh Circuit Court of Appeals.

[N.E.Hatfield]

The U.S. used to have a National Oil Co., it was called Standard Oil. We also used to have National Sugar Co., Steel Co., Coal Co. etc. etc.. Better known as the Trusts, which had some major problems. Then came along the Sherman Antitrust Act which busted them up and recreated a more dynamic economic structure and reduced prices somewhat. Nationalization is really no different than Monoply Capitalism. Though only difference is who the share holders are.

Although I would'nt mind being John D.

[Ishani]

But is the recent spike really driven by fundamentals that is, an increase in demand as you say in India or China? Or is it simply a lot speculation on Wall Street arsing from instable political situations? I understand that on the long-run, speculations doesnt matter but maybe it explains the short-term prices.

[Michael]

one problem with Posner's argument that imposing higher taxes will transfer less money to nasty coutnries like Saudi Arabia and Iran is that these countries have among the lowest production costs. Therefore if we reduce the overall demand for oil (through high taxes on petorleum products) this will of course hurt countries like Iran and Saudi Arabia. However, it will cause even more harm to production in expensive places like the Canadian oil sands. Therefore a reduction in demand for oil may make the US MORE depedendent on oil from unstable places.

[Zathras]

"Excess profits" taxes could have the effect of decreasing oil producers' incentive to develop new sources, but taxes on gasoline and other petroleum products would not.

The problem, of course, is that the time for imposing heavy federal taxes on energy and particularly gasoline use is when market prices for energy are at historically low levels. Neither Judge Posner nor Prof. Becker were conspicuous in calling for increasing the federal gas tax then. Perhaps they thought it was a non-issue.

In any event, the point of raising energy prices through taxation is not to reduce dependence on foreign sources of oil. Whether energy prices are high or low, producers with low costs of production will always have an advantage, and most of the oil producing countries with low costs of production are in the Middle East (the one nation with by far the largest reserves, Saudi Arabia, is also in the Middle East). If higher energy taxes were successful in cutting American demand for consumer products, the producers discouraged would be those whose costs of production are highest. Regrettably this includes some domestic producers.

No, the point of raising energy taxes is to guard against precisely the disruption we are beginning to see as the result of the recent run-up in market prices. Rapid price increases in so widely used a commodity are bound to create both economic and political distress among a population accustomed to using large amounts of inexpensive petroleum products. The economic distress is more considerable, and the political distress harder to dismiss, than two city-bound public intellectuals who do not need to drive very much may appreciate.

[Edward Bernstein]

Pricing may not work well here. First, demand in much of the country is not terribly elastic. People must drive to work. Morevoer in the countryside (as opposeed to chicago) the 10000 mile estimate is quite low.

Finally price takes a long time to force structural adjustments such as the production of more efficient autos and during that time lots of pain must be endured and many of us will be dead.

Remind me why (other than for some theological objection to to government regulating anything) it is not appropriate for the govenment to simply raise mileage standards.

[Dan C]

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

Posner argues high taxes may reduce oil consumption and lower world 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. And countries like China and India might just increase their demand as quickly as we reduce ours.

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. We could become more isolated on the world stage.

Just let markets work.

[laminar_flow]

Is Posner now a Engineering major? Or is Posner, a Jack of all majors and master of none.

I propose sending Richard A. Posner to a perpetuated sentence of studying the Universal Laws of Thermodynamics-Particularly the conservation of energy statuate.
This exercise will demonstrate to Richard A. Posner that Laws can be universal and absolute. Not some sliding scale of adjudicated verbatim, which Posner is so accustomed to. I.e Posner's dribble on Civil Liberty Vs Security.

Welcome to the Jungle. Albeit, a jungle with a level playing field.

[Michael Storch]

Why has there been no dramatic increase in the federal gasoline tax since we 'learned our lesson' over thirty years ago?

I have always imagined the Saudis saying 'if you want to increase taxes (income for you) to depress consumption, we will raise the price (income for us) to help you achieve that same goal'.

In other words, federal consumption taxes on gasoline do not exist in a vacuum.

Your thoughts?

[Peter]

I fail to understand the argument that because the root cause is a change in supply vs demand, the resulting profits cannot be "obscene".

If the primary cause of the rise in gasoline price is the rise in crude price, why can't that be factored into the retail price such that the oil company profits remain the same? Certainly the price of gas must rise, but why the middleman profits?

It seems to me that oil companies are preserving their profit as a percentage of retail price as it goes up, rather than as a result of the volume of gas produced, which is a more accurate indication of the value they add. From this perspective, "obscene" doesn't seem out of line.

[Peter Schaeffer]

Alas, logical arguments are only compelling if they are based on facts. Mr. Posner states that a modest income might be $40,000. If only this were true. The Census states (http://www.census.gov/Press-Release/www/releases/archives/income_wealth/002484.html) that median income for 2003 was $43,313. A "modest" income might be half that, say $20,000.

As for gasoline consumption, America consumes around 139 billion gallons of gasoline per year (see http://tonto.eia.doe.gov/dnav/pet/hist/c100000001M.htm) and we have roughly 113 million households (see http://www.census.gov/hhes/www/poverty/effect2004/table_1_020106.pdf). Together these numbers give household gasoline consumption of 1226 gallons per year, not 500. That works out to be an extra $858 dollars per year or an incremental 4.3% of your income, not 1%.

Sadly, the price of gasoline is not "much lower than it was in 1982", even on an inflation adjusted basis. One source, http://tonto.eia.doe.gov/merquery/mer_data.asp?table=T09.04, gives an average 1982 gasoline price of $1.28. The CPI has risen by a factor of 2.04 since then, which would be $2.61 today. By the way, the peak 1980s year for gasoline prices was 1981 at $1.35.

Crude oil prices are not the primary reason for recent increases in gasoline prices. Based on available data, "crack spreads" (roughly refining margins) are probably a more significant factor. See http://www.flickr.com/photos/peter_schaeffer/134694969/in/set-798097/ for some data. Note the spike after Katrina. More recent data (Bloomberg, Morgan Stanley) shows a $16 barrel expansion in crack spreads. Unfortunately, this data is not available online.

The merits of gasoline taxes are easily overestimated. U.S. gasoline consumption is only 9 million barrels a day. This is only 10.7% of world oil production (84 million barrels per day). Even dramatic tax increases aren't going to shift the world supply/demand balance that much, particularly given the dramatic growth in Asian (China, India, etc.) demand.

The importance and even the reality of global warming from Green House Gases is widely debated. I am on the "yes, it is a real problem" side of this issue, but some facts need to be kept in mind. The U.S. accounts for only 23% of global energy related CO2 emissions (see http://www.eia.doe.gov/pub/international/iealf/tableh1co2.xls). This percentage is slowly declining and is down from 26% in 1980. As Asia industrializes, the U.S. percentage will fall even further. Oil accounts for 43% of U.S. CO2 emissions. Gasoline is roughly 46% of oil consumption. This means that U.S. gasoline accounts for less that 5% of global CO2 emissions.

Thank you

Peter Schaeffer

[Haris]

Peter:

The oil are not the middle men. Gas stations and distributors are middle men, and their profits are pretty much the same regardless of the price of crude oil, as those markets are quite competitive. The oil companies operate some of these, but the bulk of their profits comes from selling the crude oil that they get out of the ground. The cost of getting that crude oil is fairly constant, although it obviously increases as more is produced. The price which that crude oil can get on the market, however, changes with demand, especially since supply is fairly inelastic in the short run. That's how the resulting profits get to be so high. There is nothing obscene about them.

[Anonymous]

more efforts should be made to find another new energy to substitute the crude oil.

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