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Gas is too cheap

Maximilian Auffhammer, professor, international sustainable development | February 4, 2016

Readers of this blog are likely aware that oil is really cheap right now. While in July 2008, the U.S. benchmark price peaked at just above $140 a barrel, its price dipped to below $27 in mid-January.

The Internet is on fire telling us that a barrel of oil is now cheaper than the equivalent volume of Perrier sparkling water or Coca Cola. But there is a much more frightening comparison: The national average price for gasoline is $1.80 this week, with a minimum of $1.29 in Tulsa, Okla.

gas prices graph

The external costs for a gallon of gasoline, as estimated in a now classic paper, are approximately $2 per gallon. This means that the average American is currently purchasing gasoline at half of its true social cost.

Now, higher oil price won’t fix the external costs, of course, and we have argued ad nauseum on this blog for a carbon tax to fix one of the market failures. Michael Anderson and I have a nice paper suggesting that one would need to charge a gas tax somewhere significantly north of $2 to make drivers internalize all of the external costs you spew on your fellow citizens faces while hurling your Dodge Hellcat down I-80 at rush hour.

But low gas prices have all kinds of negative effects for a society that does not properly tax gas. People drive more and hence cause more congestion. People purchase less fuel-efficient cars, since they think gas prices will always stay where they are any given day, which is rational. (What is not rational is that folks buy more convertibles on sunny days.) So we drive our bigger cars more on a road network that is falling apart. Bridges and highways are in terrible condition, as has been documented widely.

Stop the presses!

The smartest energy economist I know, an Energy Institute colleague, Severin Borenstein, suggested a perceived outrageous solution to this problem a while back: a price floor for gasoline. Stop the presses! A neoclassical economist suggests a price floor?

car fueling up

(Rama via Wikimedia Commons)

My version of the idea goes like this: If the price of oil drops below a certain price, say $70 per barrel, gas prices get frozen at the average local historical price for $70 oil. Yes, we would keep gas prices artificially high. This would discourage consumers from driving more and maintain disincentives to purchase really fuel-inefficient cars.

But what to do with the profits? Give it to refiners? Oil companies? No. The idea is for the regulator to capture this windfall and use it to put our highway system back together or improve public transportation systems.

You are shaking your head. Well, the Chinese are not. In the first week of January, the National Development and Reform Commission (which is China’s economic planning agency) announced that the price of diesel and gasoline would not be lowered as long as the price of oil is below $40.

This is a big deal. China had 279 million registered cars in 2015; in the U.S. the number is 257.9 million. Due to regulatory controls, the market for gasoline is less complex in China than in the fragmented U.S. market. So how one would calculate the exact floor by region would be subject to lengthy regulatory processes.

Still, the basic economics are right. While I agree that the tightened CAFE standards will improve fuel efficiency, they will not generate revenues that will prevent our then smaller and lighter cars from falling in to giant size potholes. Let’s get on it.

Cross-posted from the blog of the Energy Institute at Haas (tag line: Research that Informs Business and Social Policy).