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.

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