Thursday, September 20, 2007

High Oil Prices and Pigovian Taxes

Free Exchange and Megan McArdle both criticize Felix Salmon for having said this:
Oil just hit a new high of $81.24 a barrel this morning. This is a Pigovian tax with the proceeds going to Saudi Arabia rather than the US Treasury, but if [Greg] Mankiw is right that a carbon tax would reduce carbon emissions, then these high oil prices should be instrumental in reducing oil consumption, carbon emissions, and, ultimately, the pace of global warming.
Okay, Salmon is wrong to say a high price on oil IS a Pigovian tax. It’s not. But he’s right to say the high price is functionally equivalent to a Pigovian tax.

In their critiques, both Free Exchange and Megan assume, at least implicitly, that the market for oil is perfectly competitive. Free Exchange says the “high price of oil only reflects assessments of oil demand and supply,” while Megan uses an Econ 101 supply-and-demand graph to show the impact of a tax. If they were right, then Salmon’s claim would be incorrect; the high price of oil would simply reflect higher costs of production and/or increased demand for oil. But the market for oil is not perfectly competitive; there is good reason to think some part of the price is attributable to the oligopoly power of OPEC and other oil producers. That power is surely exaggerated from time to time – and many aspects of the oil business can be understood without it – but it’s still pretty clearly there.

As a result, we have to consider the economic theory of the second best. Simply put, this theory says that one market imperfection can offset another market imperfection. If the consumption of some good – like oil – creates a negative externality, then we should expect its price to be too low, and people will consume too much. If the market for a good is characterized by oligopoly or monopoly power, we should expect its price to be too high, and people will consume too little. But if both conditions hold, then the effects at least partially cancel out. In this sense, oligopoly pricing is equivalent to a Pigovian tax, because it pushes the price above what it would be in the presence of the externality alone.

Of course, the amount of the oligopoly price premium might be too small – or too large. Only by coincidence would it precisely offset the negative externality. But the same is true of actual Pigovian taxes as well, unless we believe the governments that set the taxes will somehow manage to get them exactly right.

(Free Exchange and Megan make some other, valid responses to Salmon’s overall position. I am only responding to their notion that the high price of oil is nothing like a Pigovian tax.)

4 comments:

J. said...

Sir, There is no way that your hypothesis on oil prices could be correct. Some say that about 20% of the price is due to speculation, and of course in the short tem, political events can make nonsense of the whole theory.
I would love to know why oil price is 4 - 5 times higher than a few years ago while no one is queuing at the gas stations.

Glen Whitman said...

"There is no way that your hypothesis on oil prices could be correct. Some say that about 20% of the price is due to speculation, and of course in the short tem, political events can make nonsense of the whole theory."

I don't see how that's an objection to my position at all.

A variety of things contribute to the price of oil, including actual costs of production, oligopoly premiums, and (as you say) speculation driven by political considerations. My point was that oligopoly makes prices higher than they should be (from an efficiency perspective), which can compensate for negative externalities that make prices lower than they should be (again, from an efficiency perspective). So what if there are other factors that drive prices up as well?

"I would love to know why oil price is 4 - 5 times higher than a few years ago while no one is queuing at the gas stations."

Because queuing results from price controls, and we don't have price controls right now. In the 1970s, we did.

caveatBettor said...

I just created a global warming prediction market here:

http://globalwarming.inklingmarkets.com/

Please sign up and trade ($5,000 of play money). Let's hope we can get a real market up and running, and better inform our policy on global warming.

diz said...

You raise a good point about OPEC. I have raised the same.

What you must understand also is that OPEC controls supply in a fundamentally more important way that production quotas.

They limit access to reserves.

And, they are stumblingly incompetent at producing their reserves. If western for-profit oil companies were allowed to develop reserves in places like Venezuela, Iraq and Saudi Arabia you'd see massive shifts of capital to thise regions and much more oil produced from that capital than we get from punching yet another hole in the US or Canada.