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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.

Maximilian Auffhammer View All

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.

51 thoughts on “Gas is too cheap Leave a comment

  1. 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.

  2. 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.

  3. 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.

    • 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

  4. 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.

    • 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.

        • There are hundreds of papers looking at this. Larry Goulder’s work is a good start.

      • 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.

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