Gas Prices, Fuel Efficiency Follow the Market

Hawaii learns with price caps debacle

We’re in a political version of silly season with hilarious jockeying over what to do about oil imports and gas prices.

President Bush is claiming we are “addicted” to foreign oil. Congressional Republicans floated, then quickly killed, a politically contrived tax rebate plan to “ease the burden” of higher gas prices. And both Republicans and Democrats on Capitol Hill are calling for investigations into price “gouging”. They’re also talking about reducing the gas tax, sapping away precious revenue needed to shore up a notoriously under-funded transportation network.

We’ve been through this before. The 1970s saw spikes in world oil prices as Middle East nations tried to choke off America’s economy. The early 1980s saw domestic gas prices spike again as we deregulated oil price controls. Watching these political shenanigans in 2006, it’s clear our leaders haven’t learned the lessons of history or basic economics.

The basic premise of economics is that prices go up if one of two things happen: demand increases while supply stays the same, or supply goes down while demand stays the same. These relationships are so well known that most social scientists-even the liberal ones-don’t question them.

Yet, watching politicians in Washington and our state houses wallow over what do to about gas prices, makes it clear they don’t grasp the laws of supply and demand.

Hawaii gets the prize for historical and economic ignorance, however. There, Republican and Democratic legislators imposed caps on gas prices eight months ago. The Hawaii law, however, added a twist. Instead of regulating retail prices at the pump, Hawaiian politicians regulated wholesale prices. Not surprisingly (to economists or historians), the wholesalers passed on their costs to the service stations.

The result?

Prices rose. And fast. One estimate by the Hawaii Department of Business, Economic Development, and Tourism placed the eight month cost to Hawaiians at $55 million. Fortunately, the legislature realized its error, relearned basic economics the hard way, and ended the program earlier this month.

Of course, all this political angst was unnecessary even if Hawaiians didn’t believe economic theory. All they had to do was look at history.

The energy crises of the 1970s, combined with deregulation of oil prices, contributed to a doubling of gas prices in the early 1980s. But then prices stabilized, and even fell slightly during the early 1990s before beginning to rise again in 1999.

How did consumers respond? Just as economics professors predicted they would. As prices went up, they conserved. They did it first, as they are now, by driving less. Then, as they realized the higher prices were permanent, consumers changed what and how they drive.

Average fuel consumed per vehicle dropped 14 percent in the 1970s and another 10 percent between 1980 and 1985. Average fuel consumed per vehicle has remained remarkably stable since then, reflecting the stability of gas prices during that period.

Meanwhile, we started driving more fuel efficient vehicles. In 1980, we were sputtering along traveling just 13 miles per gallon. By 1997, we were traveling 17 miles on each gallon of gas. That’s an increase of almost a third.

Competition helped this along, too. In 1980, imported passenger cars averaged almost 30 miles per gallon and the average domestic car clocked in at just 23 miles per gallon. By 2000, the two groups had reached parity at about 29 miles per gallon. Gas, as a share of the total costs of driving a car, has fallen from 28 percent in 1980 to 12 percent in 2004.

What’s the takeaway for U.S. policymakers and citizens? If we’re serious about conserving oil, the best policy is to let markets work. Consumers respond to higher prices, and that spurs efficiency improving technology.

We haven’t seen much change in recent years because gasoline prices have remained remarkably stable since the mid-1980s and 1990s. General inflation, housing, and medical care costs have all grown substantially faster than gasoline prices until about 2002.

So, part of what consumers are responding to now is the “shock” of a rapid, unexpected rise in gasoline prices. Consumers don’t really know if these price increases are permanent or temporary. They’re reluctant to make wholesale changes in their driving.

This will change with time. Politicians should be patient, and let markets drive changes in technology and fuel efficiency. They have a much better track record than the silly and economically na—ve policies currently gracing the headlines of newspapers and evening news programs.

Samuel Staley, Ph.D., is director of urban growth and land use policy at Reason Foundation. An archive of his work is here and Reason Foundation’s energy research and commentary is here.