Where Externalities Lie

Half Sigma:

Thanks for the reply. Yeah, the idea is not exactly to change people's behavior (I'm agnostic about people's preferences-- they may behave essentially the same) but rather to simply internalize the externalities. (I agree with your point in the blog post that cars have many positive externalities, too, and these are important.)

The (very idealized!) thought about national security policy is that it partly represents a form of "insurance" against oil supply shock, so that big reductions in oil consumption ought to allow reductions in the amount of insurance consumed. Now, there are also plenty of other considerations that drive national security policy, like humanitarian concerns, or non-economic concerns about people dying. But there is no doubt in my mind that economic security is one driver of national security policy.

To take an extreme case, if no one bought Middle Eastern oil, I think the region would have a strategic significance more like South America or Africa -- certainly still important to us, but not something we'd be nearly as likely to go to war over. (This counterfactual is admittedly very difficult to sketch out with any certainty-- lack of oil money would change the entire game in the Middle East. Nevertheless, my guess involves less money on security.)

Now in reality, we cannot achieve this counterfactual: for example, we cannot control e.g. China's energy policy-- they may consume lots of oil regardless of what we do. So because we are connected to China and other countries, we are still vulnerable to ripple effects of oil shocks even if we drastically reduce our own oil consumption. But the main point is, there is an in-principle-measurable relationship between national security expenditures and our degree of economic dependence on failed, unstable, or hostile states. I'll leave it to the experts how much of an externality that is, but it should be internalized.

Thanks, Half_Sigma!!! :-)

(FWIW, I hadn't read your blog post before you linked it.)

And to respond to Person: yes, I read your post at the top of the commens, and you make very good points, similar to my old blog post.

Hi mk. To respond to point (4) above, oil is mostly used as a transportation fuel, and there's no good substitute for it. No one has inveted an alternative fuel airplane. And alternative fuel cars don't make economic sense unless gasoline would cost at least $10/gallon, and maybe even more than that.

Even if Congress passes a law that said that no car could be sold unless it got at least 40mpg (so everyone is forced to drive around in tiny aluminum cars), it's not clear to me how this would change our policy in the Middle East.

Sigma, your post (from January) contains some interesting points. Quick response:

1) Global warming: yes, definitely we should go after the lowest-hanging fruit. I am not as sure as you are that animal methane is the lowest-hanging fruit, but whatever, let the market decide. A pollution tax would be preferable to a gasoline tax.

(your followup post shifts to arguing for nuclear power. Fine, deregulation may be quite helpful here. But that does not invalidate the argument for a pollution tax.)

2) Interesting comment on the catalytic converter efficiency. A pollution tax would again be best, and not too hard to implement (put a meter onto every new car that pays attention to startups, temperature, etc.).

3) Traffic congestion-- agreed. Again, the best solution would be a meter with a transponder that allows an automatically levied congestion tax.

4) Reduce dependence on oil. As Dan Drezner has said (and I mentioned above), the real argument here (as opposed to the oft-posed mistaken argument) supports holding a diversified portfolio of energy technologies. The risk of this resource should be built into the price. Insofar as the oil industry relies on the U.S. government to implicitly "insure" the American economy against oil volatility by holding a military and intelligence presence in the region, this cost should be paid by the people who create the need for this insurance: the producers/consumers of oil.

Oh, because I made almost the exact same points you did, while Don_Boudreaux made almost none of them, but whatever.

No, "you" meant Don Boudreaux, the author of the original blog post. The link is to a blog post explaining why it doesn't serve any sound policy objectives to reduce our gasoline consumption.

Did you mean me, Half Sigma?

I'm with you on this.

Well, I don't see how a military presence keeps an oil field from being nuked, because machine guns aren't very good at stopping those...

But okay, I'll concede the point: the military presence reduces the infinitesimal chance that a dictator will stop liking money and therefore selling his oil. It's still not a big subsidy in terms of value-added.

First of all, national security costs are NOT a true cost of providing the oil; countries would sell their oil just the same if there were no big military interventions.

I disagree. A security presence in the middle east can be thought of as a form of "insurance" that reduces the probability that the oil fields will be nuked, let's say.

Think of it in terms of a "portfolio". We are currently heavily "invested" in petroleum, but that investment carries a risk (because it comes from a volatile region). So does anything else: solar energy depends on it being sunny out. Wind energy depends on it being windy enough. Et cetera.

However, these risks are fairly different and uncorrelated. So we should seek a diverse portfolio of energy options to reduce our risk. If a person uses a lot of gas through driving, they are contributing to our economy's overinvestment in the petroleum option. This carries a cost (in risk) and that risk should be internalized.

Now, are we really overinvested in petroleum? I'll leave that to the experts, but this is the thought behind it, anyway. (As I understand it).

"The best argument out there that there are subsidies "for oil" is that the government builds lots of roads."

Aren't nearly all highways paid for through user fees? either by tolls or by gasoline taxes? Perhaps some tiny portion of gasoline is not used for transport.

Roads built by gasoline taxes may be a subsidy to electric vehicle users. Gasoline taxes and tolls used to purchase trains may be a subsidy to rail commuters. But I don't see how highways are a subsidy to either gasoline producers or to their customers. If anything, gasoline taxes reduce consumption of gasoline.

The "subsidy" argument is pretty much a red herring all around.

First, the US tax laws have next to zero effect on world oil price. US supply is a tiny fraction of the world market and zippo of the waterborne (export) market.




Second, subsidies for oil production don't exist in any material way. Look at what the new Democrat congress is doing to eliminate these supposed "subsidies": getting rid of the privilege the oil industry has to use LIFO tax accounting. [Please ignore the fact all industries use LIFO tax accounting, not just oil]

The best argument out there that there are subsidies "for oil" is that the government builds lots of roads. Of course, roads are just as usable by electric cars or ethanol cars as they are for gasoline cars. Gasoline just happens to be more efficient at meeting our human need for transportation, so we use gasoline.

Sometimes people seem to forget that transactions have "internalities" too.

methinks: I'll gladly accept the correction. The point being that the knowledge needed to drill profitably is NOT concentrated, nor all that accessible to government bureaucrats, nor is it a nationalizable resource by any nation. Sans the feedback of profits and losses, the information would lose its predictive value very quickly.

"Oil exploration isn't cheap. The capital and knowledge to do it are concentrated in large global companies."

Not even, Brad. I concentrated on U.S. independents and there's plenty of knowledge accumulated in there. Not to mention that there are companies which specialize in 3-D and 4-D seismic and sell those services to whomever. I agree with your post but I would say that the concentration of knowledge isn't with the super-majors but in free markets.

The bozos in the USSR were paying bonuses to drillers for the NUMBER OF METERS DRILLED! Of course, the deeper you drill, the slower it goes, so they ended up with big bonuses for drilling a field of useless shallow holes. Perversely, if you actual got a producing well (accidentally, of course), you were screwed on your bonus because you had to stop drilling to produce the %#@*% oil! All they did was damage the formations and spin their wheels. But hey, it's all Kosher since there were no oil company fat cats profiting off the backs of the hard working middle class, right?

You and Dismal point out exactly why state run anything is always a disaster. The only exception I know of is Saudi Arabia's oil industry, but I suspect that this is because of Aramco.

Okay, here's what I remember about subsidies:

If you're calling tax breaks a subsidy then there are subsidies. But WHY are there such subsidies?

Environmental regulations and a myriad of other expensive and restrictive regulations imposed on oil companies make it uneconomic to look for oil and gas in the United States. To mitigate some of these expense associated with regulation, the government offers tax breaks. In other words, government creates the problem it seeks to fix.

methinks: Yeah, I know what you're talking about. I mean, no one actually substantiates these oil company "subsidies", but whatever. They typically require you to interpret a slightly different amortization schedule as a "subsidy". On the other hand, when government pays people to produce renewables, that is, of course, ABSOLUTELY NOT a subsidy.

Nice Cade. Start listing the subsidies for us. Please. Enlighten us. Most of these "subsidies" that are thrown about are "below market" leases and R&D tax credits. Well guess what... You can't renegotiate the leases, and if they had been priced higher when signed, they wouldn't be signed, and we'd just import more oil. Guess what else. Oil exploration isn't cheap. The capital and knowledge to do it are concentrated in large global companies. A country like Venezuela can be sitting on a gold mine in reserves and without that knowledge and access to equipment and technology, will be pumping less oil. In the 1980s, when we imposed a windfall profit tax (call it a reverse subsidy) on the oil companies, our domestic production went down. Go figure.

Compare and contrast what you think are oil subsidies to gasoline subsidies in Iran or corn ethanol subsidies in America.

methinks -

Yes, I remember seeing similar studies.

I don't think anyone is exactly sure what the Saudis have now, but I have seen the inside of a couple national oil companies and there's nothing like rational decision making going on.

The OPEC cartel's discipline, in the long run, is probably not as big a factor in restricting the supply as polics, incompetence and corruption among the NOCs (National Oil Companies).

It seems to escape most people's attention that the world's oil is largely produced and controlled by government agents, not private entities.

One way to gauge the intensity with which these governments have developed their reserves is to compare the R/P ratios (Reserves/Production) of the NOCs versus the private companies. Many of the OPEC NOCs have R/Ps from 30-100. The typical private company is more like 10-15. R/P is a pretty good indicator of the intenity with which a company develops its reserves. Private companies want to produce their reserves quickly because they appreciate the time value of money. National Oil Companies have their capital siphoned away to buy the latest military hardware, etc.

Anyway, as I mentioned above, we can see the cost at which the private companies can find and develop oil where they are allowed to look and it's $10-$15. We can also see that they aren't allowed to look in many of the most prolific oil basins in the world, and can presume that if they were that number would be lower.

There isn't really any fact base I am aware of that would indicate the free market would produce a $60 or $70 oil price. More like $20-25, I'd say.

Surprised no one has mentioned all the various subsidies which are given to the oil companies.

Dismal,

When I was an oil industry analyst in the 1990's, we estimated that the E&P cost in Saudi Arabia ran about $2.50/bbl. Arabia has the most porous and permiable soft rock in the world. We used to joke that you could spit in the sand and create an oil seep. Oil price had not been set by the market for a long time. At the time, we estimated that without the cartel, the oil price would be around $5-10,bbl.

I don't keep up with all the research anymore but I wonder if we've exploited the "low hanging" fruit around the world and are now going after much more expensive wells at the same time that demand is spiking around the world and raising the price to make those more expensive wells more economic. There seems to be a belief in the industry that even Arabia, now producing more heavy sour than before, may be finally running at capacity. That will keep the natural oil price high - barring major changes in technology to reduce the cost of drilling. Technological changes have made it possible to drill wells today that the industry couldn't even dream about in the 1980's.

I'm not certain that the cartel is all that powerful. They tend to lose power as the oil price reaches extreme levels. After the Asian currency crisis, demand fell so much that Saudi couldn't cut its production enough to get the oil price back to the the target $20-$22 range without bankrupting the country (98% of Saudi GDP is petroleum). Now, even running at full production, the cartel can't seem to bring the oil price down because demand is so high. Thus, I agree that in the past the market price of oil was probably much lower. However, I'm not certain that this is the case today.

Some good points made already.

I'll just add that today's price for oil is nothing like what the price would be in an open market.

First and most obviously, there's OPEC. Obviously the presence of a worldwide cartel with a stated purpose of restricting supply to create above-market prices shouldn't go unnoticed.

Even if one ignores the impact of the OPEC cartel, it's still an astoundingly bad assumption to assume that oil exporting companies are models of market efficiency.

Iran, Iraq, Venezuela, Nigeria, Mexico, Angola -- investment decisions in these places aren't typically even in private hands and when they are decisions arent made like they teach you in Business School.

If you look at private oil company finding and development costs per barrel of oil where they do have access, they tend to run around $10 to $15 per barrel - and this number includes lease bonuses paid to governments to obtain drilling rights.

Private oil companies achieve these sorts of finding and development costs despite not having access to the world's highest quality (lowest cost) reserves.

I suspect if there were free and open access to worldwide oil reserves by rational privately capitalized entities you'd see something more like $20 to $25 oil again.

and rational decision making to pri

Well, of course, JP. Didn't Brad DeLong tell us that economics gave him a "tool box" (wonder if that's like Gore's "lock box") with which he could foretell externalities and slay them before they reared their ugly little heads? Surely in the right (left) economist's hands, the economy will be so smoothly planned that there will be no externalities or market failures!

People who don't know any economics complain about the rich getting richer while the poor get poorer. People who know a little economics complaint about externalities and market failure.

Seriously bcg, you were just caught posting BS to a discussion in an attempt to impugn the messenger. Go browse the faculty list for GMU's Law and Econ program... Not a Boudreaux nor a Roberts to be found! Admit your mistake, apologize, and earn some respect ;-).

But trolls aside... Partisan economists discussing tax policy are about raising the required amount of revenue in a way most palatable to their party apparatus. They then apply an ex post justification for the taxes proposed. And the non economist supporter is left to think, "oh, we have so much pollution and congestion, a gas tax hike is the only way to address the problem". Meanwhile the non-economist opposer is left to think, "they want more money" with an optional "from the middle class" depending on party affiliation. This is where this thoughtless debate deserves to stay. Our politics is a joke, but as pointed out in the China post, we manage to live pretty free in spite of it.

I guess this means Dr. Boudreaux is not a member of the Pigou Club..

"This is why I will never be white collar guy."

After 20 years at a fortune 25 company I can't imagine wanting to be a white collar guy. On a good day white collar types can't find their asses with both hands.

blue collar guy, Cute, but you missed. I'm sure our hosts could explain it better, but you pointed to a program in the Law School, not the Econ Department. Now, look at yourself in the mirror and repeat after me 20 times: "This is why I will never be white collar guy."

raise the tax on gas? no, we need to drastically reduce the size of gas tanks. I think we should have laws that reduce the size of gas tanks to no more than 2 gallons. It would serve Congress better because it wouldn't raise the monetary gas tax and they could still gain votes as a "friend" to the environment and taxpayers - that is, until people realize what a pain in the ass such a law would be....

: end sarcasm :

Don_Boudreaux: Good point, but you can go a lot further still.

This has been one of my sticking points. Anti-oil people generally bring up this externality issue and unfortunately look all too wise when they do so. I've never gotten anyone to substantiate it.

First of all, national security costs are NOT a true cost of providing the oil; countries would sell their oil just the same if there were no big military interventions. The fungibility of oil on global markets requires it. A subsidy of a false cost, is not a subsidy.

Second, if you're going to count the negative externalities of oil, you have to subtract off the positive ones. While people already "internalize" this to some extent in their purchases of petroleum products, the option to use these products is a positive externality.

Third, congestion is not a cost of oil. It is a cost of using a vehicle in a time and place where others want to do the same. Your car congests the same whether or not you power it with oil. It would justify a tax on using the roads, NOT a tax on oil.

Fourth, while roads are subsidized beyond what gas taxes cover, they are also politically apportioned and pay for far more than what most drivers actually use.

So, if you confine the costs to the *net* externality, is that more than the huge gasoline taxes that already exist? I haven't seen anyone actually work out that (honest) calculation, but it's extremely unlikely.

Untangling this web of misconceptions is easy, but tedious.

Muirgeo,

Things have been Very slowly getting more transparent in the last two years. This with Congress kicking and screaming, but a few in power pushing. Transparency has been taken a few steps BACK with the new Congress, though.

Murtha is one of the worst offenders.

Why is it that our congress does not want to vote for more transparency in how and where money is spent by government?

Posted by: lowcountryjoe

You mean why didn't the LAST congress pass bills for more transparency, because this congress has finally set about making the government more transparent.

http://www.speaker.gov/blog/?s=transparency

Blue Collar Guy,

It does look suspicious, doesn't it? And it calls into question the credibility and potential (nay, probable) bias of anyone from GMU's Law & Economics Department that would comment on the subject.

But what of the biases and credibility of all the research scientists who derive their funding by submitting reports -- to the federal government -- that lead to more research and more need for funding. My there be some incentive that exists there to keep the gravy-train rolling? How come you will not find the same information on an 'open secret' type website? Why is it that our congress does not want to vote for more transparency in how and where money is spent by government?

no externalities here:

http://www.exxonsecrets.org/html/orgfactsheet.p...>

Not yet at work so no WSJ but isn't this carbon tax policy (tax increase) tied to an equivalent tax decrease, say for example, FICA?

Well-done as usual Dr. Boudreaux!