The Gasoline Market and Government Policy

Paul Gessing is not happy with Bill Frist:

Bill Frist and Judd Gregg are the latest Republican senators to accuse oil companies of “gouging” consumers and to call for new tax or regulatory clampdowns as “remedies.” Although the populist stance against “big oil” might appeal to some beleaguered motorists, these Republicans – and most congressional Democrats – are dead wrong on the economics of proposals that would increase the level of federal intervention in the gasoline market.

He points to this letter signed by Milton Friedman, Edward Prescott, and others:

When the oil shocks of the 1970s hit, Milton Friedman and many other economists warned of the dangers of petroleum price controls and excessive energy taxes, which were then being advocated by some. Unfortunately, this wise counsel was not taken. President Nixon’s price controls were a debacle … The windfall profits tax was first enacted in 1980 as a “temporary” excise tax, which proponents said was designed to ensure that oil companies did not benefit from unanticipated windfalls caused by fluctuating crude oil prices … If it is again enacted, a windfall profits tax can be predicted to result in a diminution of domestic energy production, an increase in American dependence on foreign oil, and a reduction in the overall supplies available to consumers.

I could point out that one of the signatories to this letter was Donald Luskin who is not an economist, but there are several very respectable economists on the list of signatories. Besides, I would oppose price controls as well. My view of the oil market is that we have an OPEC-led cartel with a competitive fringe for U.S. producers. Interestingly, Jayanta Sen argues for using an import tax to impose a buyer’s cartel. Sen also suggests that a tax would reduce global warming with much of the burden of this tax being borne by the OPEC cartel rather than American consumers (hat tip to Andrew Samwick).

We should distinguish between the effects of price controls versus the effects of a windfall profits tax, which is technically different from an excise tax – but likely would have similar effects given the low elasticity of supply. Which leads me to my latest excuse to draw a few graphs based on the data from this source.

All graphs are drawn to reflect prices adjusted for changes in the CPI index with P = 1.0 for September 2005. The first graph shows the variation in the real price for a gallon of gasoline from the beginning of 2000 through September 2005. The second graph shows the contribution to this price from the cost of crude oil. Note that the economic rent captured by the owners of oil fields shot up during September 2005, but this increase was not the only element in the increase in the price of gasoline. So the third graph shows the contributions from taxes (declining in real terms over time), the contribution from distributor’s margins, and the contribution from refinery margins. Not surprisingly, the latter also shot up during September 2005. While the data is not yet out, I would suspect the refinery margins declined in October 2005 as these margins show substantial volatility.

The notion that we have a long-term shortage of refining capacity does not seem to be borne out by careful analysis. Rather – the gasoline is one of significant volatility where the owners of refinery capacity – like the owners of oil fields – enjoy economic rents during periods of shortage. The owners of refinery capacity would likely be building more capacity if there was a long-term shortage of refining capacity that generated sustained economic rents, but such does not appear to be the case.

In terms of short-term demand and supply curves, what we see is that the elasticity of supply is near zero in the short-term. Standard economic analysis would tell us that the incidence of any subsidy for this sector would accrue to the suppliers and not consumers, which is why policy wonks should oppose gasoline subsidies. I suspect, however, many Republicans actually like using taxpayer funds to grant subsidies that benefit mainly shareholders of Exxon et al. On the flip side, the incidence of a tax on such markets also likely accrues mainly to the shareholders of Exxon et al. Alas, the economists who signed the above letter failed to properly distinguish between the impact of price controls versus taxes.