Wednesday, October 19, 2005

Reducing supply or demand? 

I believe there's a misunderstanding of economics in James Taranto's latest Best of the Web. In the third item he takes on the issue of "energy independence", by which he takes it people mean to stop importing oil from the Saudis.
...our understanding of the liberal conception of [energy independence] is as follows:
  • The government should establish policies aimed at reducing the use of oil (fuel-economy standards, higher gasoline taxes, incentives or coercive measures
    to encourage use of public transit, etc.).
  • This in turn is would reduce our dependence on foreign oil, helping to starve the Arabs and thus reduce terrorism.

For the sake of argument, let's take the first part of this argument--that the government could reduce oil consumption, effectively a reduction in demand--as a given. Basic economics tells us that a reduction in the demand for a commodity will lower the price.

What happens when the price of oil goes down? High-cost oil production becomes uneconomical, which means that low-cost producers end up accounting for a greater share of the market. The lowest-cost producer of all is our friends the Saudis. Thus "energy independence," if effective at all, would actually make America more dependent on "foreign" (Arab) oil.

Not every action taken to reduce use of oil is a reduction in demand, though. While CAFE standards and incentives to public transit might indeed reduce demand for oil from private autos, taxes typically work to reduce the quantity supplied. And CAFE standards do have the effect of reducing family income, though it doesn't appear to be a large cost. Coercing people out of their cars to public transit by its very nature, destroys wealth. If it was better to take public transit, people would have gotten out of their cars already.

There's a way in which we could in fact do exactly as the "energy independence" people wish, which would be to impose an import quota or tariff on oil. Of course, the problem with this is twofold: first, the oil that would be imported would be Saudi oil, since as Taranto claims the low-cost oil is still that from the Arabian peninsula. Increasing the price of oil increases profits to firms. The US left has been hostile to increasing oil profits. Second and relatedly, a tariff on oil diverts funds from oil companies for exploration to government. I am not sanguine that those funds would be used efficiently in research and development of alternative energy sources.

(Side note: I showed this interview between Neil Cavuto on Fox's Your Money show with Lee Raymond of ExxonMobil to my class yesterday. I thought it was one of the best interviews I'd seen in a long time. One can learn a great deal about the oil business from it, and Cavuto, though sympathetic to Raymond, was thorough in his questioning.)

People naturally are led by prices to choose the most efficient method of transportation. As prices rise for oil and gasoline, individuals and firms are led to find other means of transportation, or to create more efficient automobiles. (As pointed out here, firms are already looking into cars that burn hybrid fuels that are efficient when the price of gasoline reaches $4-5 per barrel.) But politicians fear the electoral consequences of rising prices for staple goods; telling others to wear a sweater sounds so much better.