Monday, June 15, 2009

Should we smooth gas prices?

The generally very perceptive Felix Salmon makes a point that I don't think is quite right:
How to structure a gas tax? You could make it a flat X cents per gallon; alternatively (and this is essentially what a cap-and-trade system does, too) you could make it Y%, with the tax increasing with the price of gasoline.

Today, Jim Surowiecki comes up with a third option, where the tax decreases when the price of gasoline goes up...
Surowiecki makes a strong case that consumer behavior, when it comes to reducing gasoline consumption, only really changes when there’s a spike in gas prices. As a result, his proposal would seem designed to have the least possible effect on gasoline consumption, and on our dependence on oil. Sure, it’s a sensible way of raising government revenues and reducing the fiscal deficit.

Either you want to effect consumer behavior and reduce gasoline consumption — in which case you actually welcome price spikes. Or else you want to smooth out price spikes, in which case you slowly boil the frog (to use one of the stupidest metaphors ever) and keep consumption high. But you can’t have it both ways. Which is it to be, Jim?
My reading of Surowiecki (and the evidence) isn't that only sharp price changes affect gasoline consumption. A $4-a-gallon price tag will influence consumers, even if it's the product of a slow rise rather than a sharp spike. Instead, the problem Surowiecki rightly identifies is that rapid price swings cause a collapse in broader consumer confidence, damaging the economy. Their effect on consumption is so sudden that the producers don't have time to adjust, leaving us with idle capacity and structural unemployment. Needless to say, this isn't good.

Granted, price volatility reduces consumption, but the question isn't whether volatility has an effect—it's whether it is the most efficient way to accomplish our goal. There's some average tax level $X that will accomplish the same long-term reduction as a lower tax $Y implemented in a way that encourages price volatility. Assuming that they have the same effect, what's better for the rest of the economy—the higher average tax that smooths out prices, or the lower tax that leaves price spikes intact? I can't be positive without more elaborate modeling, but I'm almost sure that the higher tax is better. For the most part, avoidable uncertainty is not a efficient way to implement incentives. Indeed, Surowiecki's entire point is that gasoline dependence is odious because price changes lead to economic instability.

A related question, where I think that the issues are clearer, is the design of carbon policy. When I argue that bankable permits are an essential part of cap-and-trade, some environmentalists I know are mystified. After all, price instability will make carbon-intensive activities even less attractive. If it leads to lower emissions, why do I want to change it? Because it's an inefficient way to achieve our goals. You can implement an equally effective policy by lowering the cap slightly and allowing bankable permits, with far lesser economic and political costs. (Actually, it's not so clear that uncertainty reduces emisisons at all under cap-and-trade, because there's no incentive to push emissions below the cap. The only reason I can imagine is that consumers, fearing possible price spikes, will be more aggressive in moving away from carbon dependency, allowing future legislators to revise the cap downward. But this is pretty indirect, and the point about efficiency still holds—it's easy to forget that policies might "work" but do so in a needlessly costly way.)

Now, where does this all leave us with regard to the original proposal—Surowiecki's sliding gas tax, which decreases as the nationwide price goes up? Like I've said, all else being equal, I think that price volatility is a bad way to discourage consumption. But all else isn't equal: our power to limit volatility in the price of gasoline is limited by the reality that oil is a market, where the price much adjust to balance supply and demand. If $4 gas is necessary to reduce demand to the quantity that producers can supply, it doesn't matter what the tax is—in equilibrium, the after-tax price will be $4, period.

This is complicated a little by the fact that oil is a world market, while tax policy is implemented at the national level. With this in mind, if we implement a gas tax that moves opposite to the world oil price, we will achieve a more stable price in the United States. But this will be at the expense of even more extreme moves in other markets; since America will no longer be as responsive to price signals, prices elsewhere will have to adjust more sharply than before. If this induces other major consumers to implement similar policies, it won't be long before almost all countries attempt to stabilize after-tax prices using the same approach. And at this point, the entire policy will be worthless: after-tax prices have to move to equate supply and demand, and even the best efforts of governments can't change this on a worldwide basis. Indeed, during price spikes, a broad effort to lower gas taxes is essentially a massive transfer to oil producers.

So the ultimate answer of this seemingly endless post is no: Surowiecki's sliding tax is not a good idea. But there's a lot of nuance here about the effects of instability, and even if we rightly reject his proposal, we should make sure it's not for the wrong reason.


Chris Milroy said...

It appears you are assuming that demand or supply for oil is inelastic, such that the price will be $4 no matter how large the tax. In particular, it seems like you are saying supply is perfectly inelastic, such that producers shoulder the entire burden of the tax. Even if this is true (and there's some question about that), it is probably only true in the short run, no?

Matt Rognlie said...

Exactly -- but I feel that the effect in the short-run is the main question, because the point of smoothing out prices is to ease the effect of short-run disturbances.

In fact, the supply is only inelastic during price spikes, because capacity limits prevent producers from pumping more, and you can't borrow oil from the future. When prices go down, producers and speculators can hoard oil in anticipation of higher prices. But for exactly this reason, the most dramatic changes in the price of oil are generally spikes, and that's where the "inelastic supply" assumption is a close approximation to reality.

Chris Milroy said...

Economically, however, we would expect that the same kind of speculation that pushes up prices when they are low should reduce prices when they are high--companies hedging their positions. The existence of spikes even within the context of a functioning futures market suggests political rather than market forces are at work here.

This corresponds well with my understanding that the actual capacity of oil-producing countries is rather large and many run under full capacity in part to take advantage of oligopolistic features of the market. Saudi Arabia, to take one example, added fully 1 million bbl/d in half a year when prices rose in 2008--more than a 10% increase.

To the extent that these are political problems, the tax structure may actually affect the market even if it is "inelastic" (in the sense that once the supply numbers are set, they cannot be instantly changed).

If you're interested, there are several speeches and discussions about the political economy and market characteristics of oil at the website of a conference I ran here.

Matt Rognlie said...

It sounds interesting, but I'm not sure I understand the first paragraph. Do you mean that speculators will hoard when prices are low, preparing to sell during a spike (and thus pushing down the price)? This kind of speculation definitely eases price spikes, but it's unlikely to completely eliminate them. Storage is costly, and since the shocks to supply and demand that cause spikes are difficult to predict, speculators won't have as much oil on hand to sell during spikes as is efficient ex-post.

I don't think that futures are really the issue here. They certainly allow entities with high exposure to oil prices to hedge their risk, but unless I misunderstand the issue completely, they don't have much effect on the spot price of oil, which is still determined at the margin by supply and demand. For instance (as an abstract example), if the supply of widgets is set at 1000, and the price at which aggregate quantity demanded for these widgets is equal to 1000 is $5, then the fact that I have a futures contract to buy 500 widgets at $4 doesn't affect anything. If I am willing to buy 400 widgets at a price of $5 (which was part of the original total of 1000), then I'll sell the other 100 widgets on the open market, leaving 600 for everyone else -- which is exactly the number that "everyone else" will demand at a price of $5, meaning that the market clears and the price stays the same. Futures contracts can hedge risk, but they generally can't change the market-clearing equilibrium. (Of course, feel free to correct me if you think this is wrong.)

You're definitely right that the oil market is characterized by oligopolistic competition, but I'm not sure why this makes price spikes more likely, unless the oligopoly intentionally decides to implement them. (And it's not clear why this -- as opposed to simply maintaining a steady high price -- would be rational in the long term.) My impression is that oligopolistic producers even try to use their power to ease price spikes somewhat, and the surplus operating capacity that they maintain is another form of hoarding -- which, as I mentioned earlier, is a way to ease price spikes.

I'll make sure to take a look at the site you link.

Matt Rognlie said...

A simpler way to see why futures contracts don't affect the spot price is this: first, imagine you execute all the futures contracts. Oil has changed hands, and "supply" has changed, but in the aggregate it's still the same, and the same price will clear the market.