This just in... supply adjusts to changes in demand!

Last month, I wrote (along with many others) that one of the silver linings of the financial crisis would be that our nation's sharp mathematical minds will go into engineering and science rather than investment banking. According to Business Week, we're already seeing the effect:

"Engineering: Suddenly Sexy for College Grads"

The article ends on a high note:

"...we need our best and brightest engineers developing new types of medical devices, renewable energy sources, solutions for global warming, and ways for sustaining the environment and purifying water. And we need them to start companies that help America keep its innovative edge. So maybe the dark cloud over finance has a silver lining, and investment banking's loss will be engineering's gain."

Thomas Friedman on Alternative Energy

Here's Thomas Friedman talking about his new book and his views on global warming (here's the link from Environmental Economics):





I like that Friedman makes the following points:

1. According to the best information, Global Warming is real and requires action
2. This is a problem that can't simply be solved by government throwing money at it.
3. The price of gas does not reflect the environmental impact of carbon emissions

The issue with number 2 has to do with both incentives and scale. As far as incentives go, government spending is subject to political considerations, rather than efficiency or efficacy. Government mandates and subsidies for corn-based ethanol, for example, have more to do with the political power of the argibusiness lobby than the potential for ethanol to replace petroleum. And we've all seen how that's worked out.

Beyond incentives, there's the issue of scale. Obama, for example promises to invest $150 billion of government money over the next ten years in alternative energy research. That's a good start, but it's only $1.5 billion per year. Exxon-Mobile alone invested $80 billion in oil exploration between 2002 and 2006, or $20 billion per year. There's plenty of private money out there for alternative energy research, if only there was an incentive to invest it...

That's where number 3 comes in. While the political debate has focused on the price of gas being too high, many economists and environmentalists think that the real problem is that the price of gas is to low. As the price of a commodity goes up, people use less of it, try to make more of it, and try to find a cheaper alternative. Probably the best way to make this happen is to place a tax on carbon emissions, so that the environmental impact of using fossil fuels is reflected in the price.

Politically this is a no-go. American families are hurting from inflation and what may or may not be a recession. A candidate promising higher gas prices probably would get less votes than a Mike Gravel/Dennis Kucinich ticket. However Ted Gayer, writing in the American, makes the case more palatable for voters:

The harmful effect on labor supply can be at least partially offset by using the revenues collected from the pollution tax to reduce inefficient taxes. For example, the revenues can be used to lower marginal income tax rates, or perhaps to lower the deficit (which amounts to a future income tax reduction). Economists don’t like to see benefits go to waste, which is why Mankiw’s Pigou Club Manifesto highlights the pro-growth tax component of “an increased reliance on gas taxes over income taxes.”

Revenue from a Carbon Tax could also be used to offset a reduction in payroll taxes. That way we create a disincentive to pollute and an incentive to work. This is good for the environment and good for the economy, and could be enormously popular if properly sold. Any candidate interested?

The best way to get people to conserve

Conservative commentator Glenn Beck wrote a piece ridiculing Barack Obama's assertion that if people performed simple actions like properly inflating tires and regularly scheduling tune-ups, Americans could save a significant amount of oil. Beck's problem is with the phrase, "but if everyone did". He says:

"Saying 'we ought to' is exactly the same as 'but if everyone' -- a way to make a ridiculous point sound plausible. It's like saying: We ought to all live in peace and harmony. It's not that easy."

It's hard to argue with that on the surface. Even if Obama were president, he probably couldn't get people to conserve just by asking them. Fortunately, we have a mechanism known as the price system that can help get people to conserve. Keeping tires inflated and cars in proper condition can increase fuel economy by 7%. Maybe that's not going to change behavior at $2.00 per gallon; at $4:00 per gallon, it's a different story.

Greater energy efficiency (which is just another way of saying conservation) has to be a part of the energy solution. And price signals are great for making people act like environmentalists. As the price of gas has gone up, Americans have started driving less. When stuff gets expensive, no one needs to tell us to buy less of it.

Not the right answer

Greg Mankiw comments on Obama's plan for a "Windfall Profits Tax" on oil companies. He says that it's not really a Pigouvian tax:

"...a windfall profits tax on domestic companies discourages domestic production, but has it has no effect on domestic consumption. By contrast, a Pigovian tax at the gas pump reduces domestic consumption but has no effect on domestic production."

He also notes that since this tax will only apply to domestic oil companies (the US government does not have authority to directly tax Saudi Aramco or Russia's Gasprom), it will only serve to push consumers away from domestic oil and towards foreign oil imports. Think of it as a negative-tariff that will increase consumption of foreign oil.

Obama's proposal also includes a $1,000 tax rebate to help consumers pay for gasoline. It's a very strange plan. The problem: high gas prices. The solution: tax domestic producers (which will cut the supply) and give a tax rebate to consumers (which will increase demand). Doesn't sound like it will work, does it? Of course it's not just Obama. McCain has come up with plenty of his own bad ideas to solve the energy crisis.

Energy politics are far from rational, but the current political debate highlights American policymakers' unwillingness to admit that the US can't directly control the price of oil. But maybe that's a good thing. If US politicians could determine the price of oil, gas would cost $0.50 per gallon, Americans would drive even more than they do, and we'd be that much closer to beach-resorts in Greenland.

Do the simple things

Courtesy of Michael Gruwnwald at Time magazine.

No, properly inflated tires and regularly scheduled tune-ups will not (by themselves) solve our current energy situation. But Obama's point (and yes, he made a number of others) shows that there are many easy changes we can make that have surprisingly large effects. Tire inflation and tune-ups can together improve gas mileage by 7%. That's not huge, but it's something and it comes at a very low cost. The real question is why are Republicans spending their time ridiculing a simple, sensible idea?

Too Scary to Watch?

Dan Ariely asks a provocative question: are we overreacting to the price of gas?

No other price has as strong a political effect as the price of gas. Some presidents have been brought down by it. But while the price of gas is indisputably an important variable in our economy, it is not the only consumer good that has increased in price, nor is it the one that has increased the most.

Gas, however, is unique in that when we buy it, we stare at the running meter. As a result, we experience the increased cost of gas more vividly than other price increases. Similarly, there seem to be psychologically-relevant price thresholds for gas. The price increase from $3.50 to $3.90 per gallon is not as salient as the increase from $3.90 to $4.10 because the latter increase has crossed the $4 mark.

Judging by the letters to the editor, Ariely's argument hasn't been well received. As one woman wrote, "If Dan Ariely’s purpose in writing his Op-Ed article was to make me like the fact that I am now paying more than $4 a gallon for gas, he is mistaken."

But there may be something to what he's saying. Areily, a well known behavioral economist, is oriented to look for economic situations where people systematically deviate from the rational price theory model. A rational agent wouldn't care about arbitrary price thresholds or whether they watched the price climb as they pumped; rather he or she would only care about the price of the good, the price of substitute goods and their budget constraint.

In this week's NY Times op-ed podcast, Areily discusses anecdotal evidence of people taking thousands of dollars of losses selling their gas-guzzling SUVs in an attempt to save money on gas. This does not make universal economic sense. Consider the example of a Cadillac Escalade owner, which Areily uses in the podcast. He bought this behemoth less than a year ago for $54,000, back when the price of gas was more reasonable. Now he's stuck getting 14 mpg with gas prices over $4.00 a gallon. However, in an environment of high gas prices he can't get anywhere near what he paid for the car. In Areily's example, the SUV owner sold the car at roughly a $20,000 loss. Does this make sense? Well, if he drives 15,000 miles per year and gas increases from $4.00 per gallon to $5.00 per gallon, then his gas bill will increase by $1,072 per year. That's a lot. But it will be years before he recoup the loss on the car, assuming he even owns the car that long.

Bryan Caplan made a similar point. He observes that people have been searching harder to find cheaper gas than they did when the price was lower. While gas everywhere is more expensive, there has been no increase in the variability in gas prices. The difference between the highest and lowest gas prices is no different than it ever was, which means that the savings from searching is also the same. On the other hand, driving around searching for cheap gas is relatively more expensive.

Of course both examples are anecdotal, but they highlight some of the irrationality people exhibit when the price of gas goes up. High gas prices have caused real pain for people. But we shouldn't make things worse on ourselves.

Gas prices and global warming: what to tax?

Recently, Congress voted down a bill that would impose a Windfall Profits Tax (WPT) on the oil industry. Big Oil, awash in cash as the price of crude oil continues to rise, has seen its profits skyrocket. To put this into context, consider the following piece of trivia: if Exxon Mobil were its own country, its 2007 profit would exceed the gross domestic product of nearly two thirds of the 183 nations in the World Bank's economic rankings. Take that Swaziland!!

Of course, Big Oil's windfall earnings come at a time when the economy is slowing and many Americans, particularly in rural areas, are struggling with the price of gas. Senate Majority Leader Harry Reid recently summed up the dichotomy:

"Today, Republicans will have a simple choice: Will they continue to stand with [President] Bush, [Vice President] Cheney, and the modern-day oil barons? Or will they join us on the side of struggling American families who deserve better?"

So would a WPT work? It depends on your goals, but probably no. For people concerned about the price of gas, this is clearly a bad idea. The reasoning is similar to that used during the "gas-tax holiday" saga a few weeks ago. Paul Krugman explains it best:

"It’s Econ 101 tax incidence theory: if the supply of a good is more or less unresponsive to the price, the price to consumers will always rise until the quantity demanded falls to match the quantity supplied. Cut taxes, and all that happens is that the pretax price rises by the same amount. The McCain gas tax plan is a giveaway to oil companies, disguised as a gift to consumers."

With regard to the WPT, we can use this argument in reverse. Any tax on the oil companies will (at least in part) be passed onto consumers. The problem goes further, though. High prices and profits create an incentive to increase supply. As the price of oil increased between 2003 and 2006, oil companies increased their spending on improving existing oil fields and new field discovery by 43% and 67%, respectively. By taxing oil company profits, you dampen the incentive to invest in future production, thus decreasing future supply.

But what if, like many of us, your real concern is decreasing gasoline usage as part of a larger anti-global warming strategy? Isn't the WPT a Pigouvian tax? Well, sort of. Certainly the oil industry produces a great deal of carbon emissions. Thus taxing them may reduce their production (though it probably won't, for the reason mentioned above), which would reduce carbon emissions.

My real concern with the WPT, however, is that it sends the wrong message to the public. The public maintains many erroneous beliefs about economic policy, and opinions on gas prices are no different. According to a recent Gallup Poll, the American public cites "price gouging" as the biggest reason why the price of gasoline has increased in the past few years. While "supply and demand" did place second, other important factors like "the increased price of crude oil" (which would seem obvious) and "the decline in the value of the dollar" come in close to last. The price gouging explanation has emotional appeal, but doesn't make much sense empirically. If price gouging were a factor, why would the price of gas go up and down? And why would the worldwide price of gas go up, rather than simply the price of gas in the US?

Passing a WPT would send a dangerous political message to Americans, reinforcing their beliefs about the price of oil. But it would also be unfair to solely blame oil suppliers for the problem of pollution. People don't use oil because the oil companies exist; oil companies exist because people demand oil. As a result, taxing oil companies, rather than everyone (individuals and businesses) that uses oil (and thus directly producing carbon emissions) would be an ineffective measure for curtailing global warming. Alternatively, a carbon tax, which would tax the emission of CO2, rather than the production and sale of oil, would be a much more effective Pigouvian tax that would actually change people's behavior and would actually help the environment. Additionally, a carbon-tax does not have to be regressive. Rather, as Jason Furman notes, the carbon tax could be paired with reductions in other taxes, such as the payroll tax, so that low and middle-income taxpayers do not see their tax bills increase. That way we tax polluting behavior and not income.

The WPT is, at best, an ineffective half-measure and is, at worst, cynical political scapegoating. If we want to take global warming seriously, we need to tax polluting behavior; you do not need to have any sympathy for the oil companies to see that. And, yes, tax breaks and other incentives for oil companies are nothing more than "Conservative Nanny State" policies, which have to stop. But don't shed any tears for the WPT. As a measure for solving climate change, it won't work; as a means of scoring political points, it probably will.