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The Simple Theory vs. Difficult Practice of Reducing Gasoline Prices

June 19th, 2008 . by economistmom

Gasoline prices are pretty much front and center in the political and economic news lately.  Today’s front page of the Washington Post reports on President Bush’s call to reverse the ban on offshore oil drilling–a position Senator McCain has also taken.  Those who support more drilling argue that this would help bring down gasoline prices.  The theory is simple, as economics teaches us that one way to reduce the market price of a commodity is to increase supply (shift the red line above to the right).  Of course, the theory of “supply and demand” also tells us that another way to reduce the market price of a commodity is to reduce demand (shift the blue line above to the left).  In the case of the gasoline market, while either strategy would bring down the market price, they would have quite different implications in terms of the allocation of resources, the distribution of income, and the impact on the environment.  But the price effect alone seems pretty straightforward.

In practice, however, bringing down the market price of gasoline is difficult and slow.  On the supply side, it’s difficult and slow because new drilling takes some time, U.S. oil supply is just a small fraction (looks to me like 7%) of global production, and as a 2005 Dept. of Energy-sponsored analysis (on the peaking of world oil production) notes, “the earth’s endowment of oil is finite.”  (Darn, the old infinite wants vs. finite means problem…)  Today’s Washington Post story notes:

A major uncertainty is the economic impact of offshore drilling, which by Bush’s estimate could result in an extra 18 billion barrels of oil — equivalent to the nation’s current oil production for the next 10 years, according to the White House. Hennessy said he thinks that oil prices might fall as markets began building in the expectation of a growing supply. “We would expect it to have an effect on the price; it’s very difficult to quantify,” he said.

But the federal Energy Information Administration estimated that if leasing began in 2012, “access to the Pacific, Atlantic and eastern Gulf regions would not have a significant impact on domestic crude oil and natural gas production or prices before 2030.”

Wow… By 2030 I’ll surely be more worried about my health care bills than my gasoline bills…

And on the demand side (the approach Senator Obama seems to favor), it’s difficult and slow because to encourage a reduction in demand (and eventual reduction in price), you have to be willing either to let the market (or even “help” the market) bear some short-term pain (immediately higher gasoline prices that shock consumers into changing their habits and preferences) or to subsidize alternative energy technology (so that vehicles that use such technology become cheaper to the consumer).  The former is politically difficult, the latter sounds like it could get expensive, and both are probably pretty slow to take effect. 

I like the Environmental Economics blog’s expert opinion on how to best deal with $4/gallon gas:  drive less.  There’s very little that policy can do on the supply or demand side to change the market forces that have brought gasoline prices higher over the past five years, there’s very little we can do now to push against those market forces, and why would we want to?  The market has sent the “signal” of higher prices for a very valid reason:  we’ve been consuming too much.

(Hate to admit this after what I just said, but next week my family will be driving a big SUV while my family’s on vacation out west.  It’s the only kind of vehicle large enough to hold all 6 of us and our luggage, so maybe that’s still an optimal choice on a per-person fuel-efficiency basis.  Even in a big vehicle, we still really pack it in.  I will definitely be trying to figure this out and will report on it while on the road.)

4 Responses to “The Simple Theory vs. Difficult Practice of Reducing Gasoline Prices”

  1. comment number 1 by: Michael Perkins

    Sure would be nice if the high prices were because we were charging a pigou tax on fuel, to offset other taxes in a revenue neutral manner.

    Have any data on what likely reductions in prices would be if we reduced driving by, say, 2%?

  2. comment number 2 by: dilbert dogbert

    The market for oil is a world market. If we up our production, it reduces, slowly, the world price which allows the Indians and Chinese and the rest of the world to use more oil. The oil use I forgo today will not keep my grandchildren warmer in the future.

  3. comment number 3 by: pgl

    Six people! Wow - at least your leaving the dog at home. Have fun on the vacation!

  4. comment number 4 by: Terry Carruthers

    “I like the Environmental Economics blog’s expert opinion on how to best deal with $4/gallon gas: drive less.”

    Isn’t that exactly the demand side approach? Let the market dictate the current price and respond to that price by planning for the future — reduce our need on the resource in current demand and begin to develop alternatives to the market.

    The best way our governnment can help with this situation is to encourage the adoption of alternative fuels and the sooner they start encouraging alternatives the faster the markets can be influenced and the better off the country will be. We should have continued to do what we started out to do in the 1970’s — the use of fuel-efficient small cars for commuting — and not let our cities continue to sprawl.

    This “crisis” comes at a bad time with the downturn in the economy but it is not something we can’t work through.