The Cost of Not Raising Gas Prices

By Donald Losman

Published February 10, 2006, issue of February 10, 2006.
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Although Americans have been grousing about the price of gasoline, the truth is that pump prices are still not high enough. As high as prices might seem today, they do not reflect the true costs of oil.

The free market normally does an excellent job of allocating society’s scarce resources because prices usually incorporate all relevant costs and benefits. But if prices are inaccurate, then the market misallocates. Such is the case when there are meaningful externalities, or situations in which parties other than those directly participating in a transaction are impacted — in layman’s terms, when there are hidden costs.

While economists have become far more sophisticated in their analyses of externalities, inaccurate pricing still occurs, with oil being a prime example. Such negative spillovers, as they are often called, carry a heavy price, for incorrect oil pricing has very significant impact on national security, the environment, balance of payments, and social issues, in addition to the standard resource misallocation effects.

Oil imports entail a very unique negative spillover, given today’s global security environment. The garnering of oil revenues by Middle Eastern states and individuals fuels the purchase of weapons used against our own forces and citizens, as well as those of our friends. It also funds madrassas, or religious schools, that teach hate to potential terrorists. Americans are thus subject to greater loss of life, property and other costs. If Norway or Canada were the world’s only oil producers, no such negative spillovers would exist. Since this is not the case, oil is clearly more expensive than the contractual prices.

The better-known, more standard negative spillovers associated with oil include environmental costs and a wide range of human health issues, from allergies to lung disease. As was the case with steel during the 1950s and 1960s, real costs imposed on society are not reflected in market-determined prices.

Nor are the annual costs of maintaining the Strategic Petroleum Reserve, which is funded via the federal government. Other omitted costs include the fact that cheap gas, by inducing more driving, is associated with more traffic accidents and greater road congestion, not to mention increased highway maintenance.

Further, the rationale for maintaining costly Arabian peninsula troop deployments and a large naval presence in the Persian Gulf has been anxiety over oil supplies and prices. Although Saudi basing is phasing out, our presence in Qatar is expanding. Accordingly, if troop and naval deployments — and their associated costs — are deemed necessary to ensure access to oil, these expenses should be reflected in end-user prices, just as the oil companies’ shipping, fire and business interruption insurance expenses are. But this is not the case. They come out of Department of Defense funds. This, too, contributes to an artificially low price that pumps up oil usage.

Estimates of these various costs differ widely because they are inherently difficult to compile, embody many methodological approaches and often reflect ideological biases. In my view, “internalizing” these externalities would raise today’s regular gas to $3.60 a gallon under the very best scenario and $5.60 under the worst.

The mid-point — $4.60 a gallon — is probably the most reasoned estimate, a level that would send chills down most Americans’ spines, but find Europeans yawning or envious. In Amsterdam today the pump price exceeds $7 per gallon, which is also the price in Norway, one of the world’s largest oil exporters; in London it is more than $6.

This more accurate American gas price would raise the tax component from roughly 44 cents today to $2.80, about 50% of the accurate pump price. In Europe, by contrast, the tax share averages 60%.

In addition to pinching family budgets, many Americans fear that such seemingly sky-high gas prices would guarantee a recession. Such concerns, however, are misplaced. The American economy, far larger than a combination of the three European ones mentioned, can easily accommodate such pricing, and particularly so if it is appropriately phased.

The closer-to-home fear is that such prices would force us to modify our lifestyles, as the recent sharp decline in SUV sales indicates. But that is the whole point. The bargains Americans have had at the pump have obscured very significant costs, misallocating many resources — and not just oil.

With more accurate pricing, all energy would be utilized more carefully. Carpooling, mass transit and more fuel-efficient autos would be greatly encouraged. Proper pricing would most certainly lessen pollution and reduce wear-and-tear on the roads. With oil imports constituting 37.5% of the record trade imbalance reached this past October, our current account deficits would be lower. And Corporate Average Fuel Economy standards — with their intrusions upon consumer choice as well as the cost of the games Detroit plays to navigate around them — would be unnecessary. Road congestion would also lessen as higher gas prices encouraged carpooling and alternative modes of travel.

The worry that higher gas prices would impose impossible burdens on the poor as well as on the trucking industry could be mitigated by tax rebates, or gas stamps modeled on the food-stamps model. Remember, the goal of higher pump prices is not to boost government revenues, but to price oil more accurately .

Perhaps most importantly, reduced oil demand by the world’s largest user would also lead to lower crude prices and a great boon to the global economy. While this new domestic price would not end our need for imports, it would certainly swing bargaining power in our direction. Furthermore, we would be devaluing the wealth and income of states supporting terrorism. Serendipitously, revenues formerly channeled to the OPEC member states would go instead to the U.S. Treasury.

And finally, lower valued oil and less dependence upon it means less dependence on the Middle East. If President Bush wants to see a substantial cut in America’s oil imports, proper petroleum pricing is the way to go.

Donald Losman is a professor of economics at the National Defense University in Washington, D.C. The views expressed are his own.






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