Gas is too cheap

Readers of this blog are likely aware that oil is really cheap right now. While in July 2008, the U.S. benchmark price peaked at just above $140 a barrel, its price dipped to below $27 in mid-January.


The internet is on fire telling us that oil is now cheaper than the barrel (it actually doesn’t) come(s) in, the equivalent volume of Perrier sparkling water or Coca Cola. But there is a much more frightening comparison. The national average price for gasoline is $1.80 this week, with a minimum of $1.29 in Tulsa, Oklahoma. The external costs for a gallon of gasoline, as estimated in a now classic paper, are approximately $2 per gallon. This means that the average American is currently purchasing gasoline at half of its true social cost.

Now, higher oil price won’t fix the external costs of course and we have argued ad nauseum for a carbon tax on this blog to fix one of the market failures. Michael Anderson and I have a nice paper suggesting that one would need to charge a gas tax somewhere significantly north of $2 to make drivers internalize all of the external costs you spew on your fellow citizens faces while hurling your Dodge Hellcat down I-80 at rush hour.

But low gas prices have all kinds of negative effects for a society that does not properly tax gas. People drive more and hence cause more congestion. People purchase less fuel efficient cars, since they think gas prices will always stay where they are any given day, which is rational. (What is not, is that folks buy more convertibles on sunny days.) So we drive our bigger cars more on a road network that is falling apart. Bridges and highways are in terrible condition, as has been documented widely.

The smartest energy economist I know and Energy Institute colleague, Severin Borenstein, has suggested a perceived outrageous solution to this problem a while back. A price floor for gasoline. Stop the presses! A neoclassical economist suggests a price floor. My version of the idea goes like this. If the price of oil drops below a certain price, say $70 per barrel, gas prices get frozen at the average local historical price for $70 oil. Yes, we would keep gas prices artificially high. This would discourage consumers from driving more and maintain disincentives to purchase really fuel inefficient cars.

But what to do with the profits? Give it to refiners? Oil companies. No. The idea is for the regulator to capture this windfall and use it to put our highway system back together or improve public transportation systems. You are shaking your head. Well, the Chinese are not. In the first week of January, the National Development and Reform Commission (which is China’s economic planning agency) announced that price of Diesel and Gasoline would not be lowered as long as the price of oil is below $40.

This is a big deal. China had 279 million registered cars in 2015. In the US this number is 257.9 million. Due to regulatory controls, the market for gasoline is less complex in China than the fragmented US market. So how one would calculate the exact floor by region would be subject to lengthy regulatory processes. Still, the basic economics are right. While I agree that the tightened CAFE standards will improve fuel efficiency, they will not generate revenues that will prevent our then smaller and lighter cars from falling in to giant size potholes. Let’s get on it.

About Maximilian Auffhammer

Maximilian Auffhammer is the George Pardee Professor of International Sustainable Development at the University of California Berkeley. His fields of expertise are environmental and energy economics, with a specific focus on the impacts and regulation of climate change and air pollution.
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49 Responses to Gas is too cheap

  1. Alex Gilbert says:

    There are certainly potential benefits from setting a floor price for gasoline, particularly in preventing backwards movements in fleet fuel economy and limiting GHG emissions. However, such a proposal does have one major drawback: it limits the ability of demand to respond to low oil prices – which would only increase oil price volatility and could cause oil price downturns to be more severe and more prolonged.

    The current downturn is a key case in point. The current downturn started because increasing U.S. oil supply limited the influence of OPEC, which in turn vastly increased production to maintain revenues even as prices fell. This led to a massive supply-demand imbalance. Most supply generally takes years to respond to price declines but demand can be more responsive. In the U.S., where gas taxes are low, this has indeed been the case. But globally, gas taxes or subsidies abroad limit the demand response in European and other oil markets, meaning that oil prices had to go down a lot further than they would have otherwise. The lack of increased demand has thus only exacerbated the supply glut and led to lower oil prices than would have otherwise occurred (with a potentially longer duration).

    This is not to say that a gasoline price floor or similar mechanism is without merit. But consideration of any such mechanism needs to recognize knock on effects that could limit that mechanisms’ effectiveness.

  2. Thank you for the educative review that includes lots of important literature. The idea of price floor is a nice one and can be really economically justified keeping in mind high external costs of oil. However, following your line of thought, the use of the windfall of profits should at least partially be directed to development of efficient public transportation, green energy solutions etc, to provide better alternatives for polluting private transportation.

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  4. Azmat says:

    “A neoclassical economist suggests a price floor. My version of the idea goes like this. ” This would be OK with me IF there was a ‘price cap’ too. Either you want a free market or you don’t. Either you want simple tax policy or you don’t. you cannot have the ‘on the one hand, on the other hand’ policies. Since ‘society’ owns the ‘social goods’ it can set the prices. Currently we are paying the external costs of carbon in the form of ‘wasted’ time traveling [due to congestion], healthcare expenses, etc. in a perfect world the charge for carbon would be ‘extracted’ at the point where the resource is extracted from the ground, then it would certainly get passed on to the user. The impact of carbon emissions are global, so the extraction tax should be at the source — effectively increasing the price of oil/b. The luck of the draw would mean that oil-rich countries would get a windfall .. so be it.

    • Steven/Setty says:

      This was basically what Colombia did with its fuel price stabilization fund. It taxed heavily during the last fuel price drop, and subsidized somewhat as fuel prices rose. The problem is that nobody knows how long a high price will last. By subsidizing fuel when it’s expensive, you of course encourage people to keep using it…boosting consumption and extending the period of high prices. It is very hard to design a fund like that to last through an extended period of very high prices.

  5. Mark Barteau says:

    You might be interested in my recent commentary on this subject:
    Even if we only captured 20% of this windfall for public purposes, we could tackle a number of problems.

  6. I am not opposed to the idea of such a price floor but I do not see how it could be implemented. Suppose a price floor of $2.00/gal. Wouldn’t the gasoline price at the pump end up being $2.01/gal so that all the rent is captured within the gasoline supply chain rather than by the government? It seems to me that a price floor would facilitate collusion and the government would get nothing out of it. A tax rate that is inversely proportional to gasoline price seems like a better idea, although it brings other complications.

    • mcubedecon says:

      Sebastien, good point about facilitating collusion. However, if the price floor is pegged to the price of international oil, e.g. Brent or WTI, then California companies won’t be able to manipulate the price in this manner.

  7. A starting point for discourse on gasoline prices has to be the pathetic acknowledgment that, in this country, no gasoline price is ever low enough — a cultural constant that, year after year, paralyzes the national leadership of both major parties. Maybe it was that recognition that impelled the Editorial Board of the NY Times (Jan 16), in looking to higher state gas taxes, to identify Federal lawmakers as “so fearful of raising taxes ahead of an election that they refuse to do so.” Alas, linking that deadlock to pending elections is an inviting, but skewed, account of the issue. Take note: it’s been President Obama, who has steadily and explicitly declined to support an increase in the federal gas tax — unchanged at 18.4 cents/gallon since 1993 — and now dependent on fiscal legerdemain by the current Congress to bail out the strapped Highway Trust Fund. Never mind that there appeared, fleetingly, a hint of some bipartisan Congressional willingness to at least contemplate a rise in the gas tax. Presidential leadership might not have been sufficient to break the impasse. But it surely would have been necessary.

  8. This is what happens when academics think reality is an excuse to let go of moral principles and the core values of a society. To drive in a big fast car, alone, anywhere I want, with no traffic lights and free parking when I get there–these are constitutional rights and the basis of American identity. You could look it up. Why should I care whether the planet is habitable, if all my important freedoms are taken away and life isn’t worth living?
    You are also violating a fundamental political norm by talking about taxes and services in the same essay. These have nothing to do with each other: taxes should be low, especially for me, and I have a basic right to good uncongested roads to drive on toll-free. Completely unrelated topics, please do not confuse them in the same post.

  9. Scott Van says:

    It is not proper to cite the RFF paper as support for the assertion that there is a $2/gallon external cost of gasoline. The authors calculated the external cost of automobiles, not of gas. Most of the cost was for traffic congestion and accidents, which are results of personal mobility, regardless of fuel. They put the fuel related external cost at 18 cents/gallon. Of that, only 6 cents/gallon was for “greenhouse warming.” The paper doesn’t support a carbon tax of meaningful size.

    • Maximilian Auffhammer says:

      I never made the assertion that this is the greenhouse gas externality. The text is careful about this. This is the total externality.

      • mcubedecon says:

        But Max, he’s correct that much of the externality is from “cars” and not from “fuel.” They don’t go away with EVs. Researchers have been making this mistake for a couple of decades.

        • Maximilian Auffhammer says:

          I get that clearly. My argument was simply that higher gas prices lead to less driving and purchases of more efficient cars. This post is not about a gas or carbon tax, but about a price floor on gas.

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  11. Raising the gas tax to mitigate the external costs of driving will only be efficient if the extra revenue is used efficiently. For example, California Governor Brown used part of the CO2 tax to fund high speed rail even though high speed rail only reduces CO2 production at a cost of thousands of dollars per tonne. This will have no meaningful effect on CO2 production. Another example is building new rail commuter lines has proven so costly per passenger mile that in most markets there is no significant mitigating effect on driving.

    So an extra tax on gasoline should only be levied if the revenue goes to the most efficient way of reducing external costs.

    • mcubedecon says:

      Paul, Pigou proved in the 1920s that efficient resource pricing through his Pigouvian tax need not be tied to the use of that tax for a specific purpose. In fact, the use of that tax revenue to subsidize the reductions of GHG in another manner is INefficient. The better use of that tax revenue is to offset other “general” taxes which create economic inefficiency, such sales, income or property taxes unrelated to noxious activities.

      • I am not familiar with Pigou’s work, but doubt just a general tax on GHG emissions that is then put into general revenue would work. Tax money is not spent on the most efficient policies but on the those that benefit groups with the most political power. For example, even as we contemplate GHG taxes carbon based energy still gets some government subsidies because of their political power. Just using the example of some of the California carbon tax being used to subsidize high speed rail, which has never been a viable project, is another example. With a carbon tax all rebated to the public it might have enough political support to pass. It is revenue neutral, so some Republicans might support it, and it only penalizes those who use a great deal of energy. The incentives would support new development of energy that doesn’t release GHG at a low cost. See for more information.

      • mcubedecon says:

        Paul D. Brooks, the Climate Fee & Dividend is exactly the method I’m talking about–it provides a direct rebate to households with no tie to be used for GHG reduction. (In fact, the dividend is likely to lead a small offset to GHG reductions through the income effect of increasing energy purchases.) This is the type of method that Goulder and Ian Parry have proposed. You’re arguing against yourself.

    • Re: “Raising the gas tax to mitigate the external costs of driving will only be efficient if the extra revenue is used efficiently.”

      Technically speaking, if you accept economic efficiency as a guide, raising the gas tax is only efficient if the proceeds of the tax are used to compensate third-party persons harmed by the externality generating activities. Diverting funds to other uses may attain some “second best” goals, but not best efficient outcomes.

  12. After discussion with other it maybe that the “now classic paper” by Parry et al. cited in this article is debatable. First, auto accidents and congestion are internal costs, not externalities. Second, most air pollution (not to mention accident) costs have significantly declined since the paper was written. Third, Mark Delucchi’s research on the same subject was thorough and found lower costs. Apparently there is considerable debate on the actual real external costs.

    • Maximilian Auffhammer says:

      Dear Paul: We can quibble about the right number. Sure. Look at the hidden cost of energy report by the national academies, my linked paper with Mike or any other review. The right number is somewhere between a dollar and two probably. But the statement that “auto accidents and congestion are internal costs” wins the prize for factually most incorrect statement I have heard in the past five years. It is simply not true. You enter the highway, you slow everyone else down. You buy a big hunk of steel to transport your little kids in, you are more likely to kill someone in an accident. Both are classic examples of an externality. Max

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  14. I agree that if a vehicle hits a pedestrian, then that is an external cost. However I think it is much more debatable that “You enter the highway, you slow everyone else down” is an external cost. It can be argued, and I have ridden with people entering a highway, “why are these other cars on the highway slowing me down?” All the cars on the highway have made a choice to bear the cost of the congestion they cause, they just blame it on all the other cars. Therefore I would argue that it is a collective internal cost. That is, the cost is being born by the user. The same for auto accidents on a freeway with no pedestrians. The risk and at least some of the cost is being born by the user of their own will.

    It should also be noted that the reason drivers suffer this cost is driving is still the most cost and time efficient way of travelling or a combination of travelling to get a living choice they can afford.

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  19. Ed Wood says:

    Of course, the benefits to society adds up to 7$, so I’m good with being 5$ ahead.

  20. It always amuses me when people who live in congested areas think nationwide policies are needed to address their localized issues. Economists say to think on the margin, and the marginal gallon of gasoline I consume in West Texas when I live under 2 miles from my office imposes essentially zero congestion externally on anyone. Fund your own infrastructure.

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