Feds Should Let Gas Prices Run Their Course

Higher gas prices will transform the automobile industry

On Monday U.S. Senate Democrats released a study concluding that Big Oil is doing what most Americans suspected anyway – using their market power to raise prices above competitive levels. Oddly enough, this may be good news for the American economy. Big Oil’s use of its market power may generate larger, more broad-based social benefits than critics might realize. As Joseph Schumpeter is famous for pointing out, industry profits encourage innovations that reduce that profit, but create profit for entrepreneurs.

Of course, whether the major oil companies are conspiring to keep gas prices high is at least debatable. After all, as the study points out, the causes of gas price fluctuations are complex, ranging from crude oil prices to refining capacity, seasonal demand, and air pollution regulation. The Senate study focused on domestic refining, not incorporating the effects of increased crude oil prices in 2000 and early 2001. Refining profit margins increased in 2000 and the first half of 2001, before crashing post-September 11.

Nevertheless, the Senate study’s conclusions raise a more important question: So what? Are higher gas prices really a bad thing? Many analysts, including environmentalists, argue that one of the fundamental problems with America’s transportation market is that driving (and gasoline) is too cheap. Oil is a fossil fuel, and its supplies are finite (although analysts really don’t know precisely how large global reserves are). Conservation, then, should be a laudable goal of public policy. Prices are an important tool for promoting conservation.

Environmentalists argue further that the “boutique fuels” that the Environmental Protection Agency implemented in 1995 internalize some of the environmental costs of gasoline consumption. However, the array of boutique fuels in different metropolitan areas, especially in the Midwest, fragments markets and makes both demand and supply less responsive to price changes. Diminished price responsiveness leads to higher and more volatile prices. And as we have seen in earning declarations in the past month, profits are more volatile too, as oil companies bear the cost of the market risk associated with recession in their lower refining margins.

Price responsiveness is one of the key components in achieving economic efficiency. After all, one of the primary purposes of a product’s price is to give consumers and producers information about how scarce goods and services are. Higher gas prices provide a strong signal to consumers that gasoline is becoming more scarce, or that the cost of making it has increased. The higher the price, the less consumers will use.

Higher prices will have at least two effects in the transportation market, both of which have substantial potential long-term payoffs. In the short run, consumers will use less gas: We will combine trips to cut down on the gas used to start and run our cars; we will use the smaller, more fuel-efficient car rather than the gas guzzling van or SUV; more people will opt for telecommuting. We might even shorten our trips, or begin to carpool. Gasoline demand is not very responsive to price changes, but some decrease in demand would occur nonetheless.

In the longer run, higher gas prices will transform the automobile industry, just as they did three decades ago. Many baby boomers may nostalgically remember their first VW bug or van in the 1960s, but foreign cars really gained their foothold in the American car market when gas prices skyrocketed in the 1970s in the wake of OPEC and domestic oil price controls that persisted until 1981. Volkswagen and Nissan benefited early, but soon Toyota and Honda rounded out the market in the early years of this price-and-regulation-induced transformation.

Now, unlike earlier decades, American automakers are poised to reap the advantages of a more conservation minded auto-buying public. Those unprofitable small car lines will become economically viable as gas prices increase. In addition, higher gas prices will fuel consumer demand for hybrid cars, which boast 60 or more miles to the gallon, as well as encouraging investment in research into new technologies that reduce or eliminate the use of gasoline.

Of course, if these changes occur – and we have lots of experience in the market to indicate they will – history will show that Big Oil will get its comeuppance through the discipline of the market. As people switch to more fuel-efficient cars or change their driving habits, and technological change reduces our use of fossil fuels, profit margins in the oil industry will be squeezed even more and the overall demand for gasoline (and oil) will fall. What look like monopoly profits now may disappear if the industry does not innovate to deliver better alternatives to customers.

Of course, even if we believe that lower gas prices are better overall, the notion that the federal government can jump in effectively to address this “problem” is remote. As the tone of the Senate study suggested, intervention is likely to target keeping gasoline prices down – a move that might reap short-term gains with voters but is likely to discourage socially beneficial and efficient changes in the market.

Oddly enough, the Senate report on gasoline prices makes a stronger case for letting the market run its course than federal intervention to try to make things “right.” For the sake of argument, assume the cost increase from the EPA “boutique fuel” policies does internalize environmental costs and gets passed on to consumers. Higher gasoline prices signal to consumers and innovators that they should pursue other alternatives. Artificially reducing gasoline prices will succeed in prolonging our dependence on fossil fuels beyond what makes economic sense. Instead, let the oil industry fly or fall in the perennial gale of creative destruction – consumers, innovative entrepreneurs and the environment will be the ones who benefit.

Samuel Staley is director of urban and land use policy at Reason Foundation and co-editor of the book “Smarter Growth: Market-Based Strategies for Land-Use Planning in the 21st Century.”

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.