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June 30, 2008



"...it's a combination of a transfer from the US government to drivers-- a rather progressive transfer!-- and a small reduction in good incentives."

As you point out, supply is fairly inelastic in the short and medium term, as is demand. The majority of the transfer, then, would actually be to the producer rather than the driver. In the long term more of the transfer would indeed be to consumers, but the policy in question is explicitly short-term - as it should be, considering the large negative externalities of oil dependency. Further, driving up oil profits is just an enticement to nationalization, or little sibling policies like "windfall" taxes.

Offshore oil drilling should probably be allowed on general principles, and I certainly encourage it when it makes economic sense (including the cost of environmental damage and/or protection measures), but I dispute the idea that it's somehow important. It's just such a small effect - a ~4% savings, according to the analyses I've seen - achieved so long from now - a decade or so.

McCain's $300 million battery prize is more likely to be important, though again it seems like an ill-thought out gimmick, given that everyone from GM to Silicon Valley VCs are already pouring resources into battery technology. Perhaps he should award it to those who achieve a more intelligent power grid.

The single biggest thing that would reduce gas prices in the short term would be to stabilize the Mid-East, of course. A great deal of uncertainty has been built into the current pricing, and recent stories about "preparing the battlefield" in Iran have made that worse. Hersh is neither helpful nor do I regard much of his recent work as credible, but rhetoric coming from the US and news from Israel lends unusual credence to the idea that an additional conflict may soon interrupt oil supplies. Calming that could cut a dollar off a gallon.

Nathan Smith

"As you point out, supply is fairly inelastic in the short and medium term, as is demand. The majority of the transfer, then, would actually be to the producer rather than the driver."

Wait a minute. If supply and demand are both pretty inelastic, doesn't that mean the incidence of a gas tax holiday would mostly be a transfer from the government to the driver? Lowering the tax reduces the domestic price. That evokes a response from demand, but, *ex hypthesi*, a small one. The small increase in demand will raise the before-tax price slightly, thus offsetting part, but not much, of the tax cut. Meanwhile, the increase in the before-tax price of gasoline might actually evoke more supply, but, due to inelasticity, very little. The higher before-tax price of gasoline means that a small amount will be transferred to oil producers, mostly foreigners. So the gas tax holiday would be a transfer partly to the House of Saud et al., but mostly to American drivers, at the cost of reducing the efficient demand-side response to higher prices (and, at the same time, slightly boosting the supply-side response). The fact that the gas-tax holiday is temporary especially reduces its effect, because people making long-term investments in a reduced-gasoline lifestyle, or in new oil drilling, shouldn't take it into account.

Actually, it occurs to me that what would be really smart would be to combine a gas-tax holiday, providing short-term relief, with a scheduled rise in the gas tax, which could offset the fiscal effect, while providing a warning that over the long horizon people should be moving towards alternatives as much as possible. Of course, one gas tax holiday might signal more to come, which could get really economically stupid, and maybe that's what economists are reacting against. But it's interesting that McCain's proposal was for a *temporary* holiday. A critique that McCain wants to set a precedent which could evolve into an irresponsible policy would be more justified than Mankiw's single-minded crusade.

Yes, calming tensions with-- or, from the other point of view, appeasing-- Iran might lower oil prices. And of course, it might be a good idea on the merits even aside from the economics. But I'm wary of letting our oil demand affect the way we deal with things like nuclear proliferation that are arguably vital national interests.


"supply is fairly inelastic in the short and medium term, as is demand" was a mis-edit on my part. Supply is fairly inelastic *relative to* demand, which is itself not particularly elastic. That is to say, the market equilibria are pretty deep into the steepest part of refineries' supply curve during the Summer, and so even given relatively inelastic demand, the fall in equilibrium prices is small even compared to the meager boost in quantity. Nothing noticeable happens except that oil companies' margins go up. That said, my understanding is that at other times of year consumers can get up to half the savings.

As for Iran, I think our saber-rattling (along with Hersh's stories of assault planning) is doing more to prop up Iran's regime* than anything, which encourages them to continue to provoke the international community. One of those ways, of course, is to quarrel about nuclear weapons. Considering how much more vulnerable to popular discontent Iran is than, say, North Korea, I suspect a strong sanctions regime would be far more effective than offering an external threat, which tends to quell internal dissent. If we further lowered the price of crude (thus cutting into an important source of government largesse) we would do still more damage to anti-Western elements in the Iranian government. Failing to comprehend the difference between Persian and Arab culture as well as the difference between Saddam and Ahmadinejad is causing McCain to approach the problem exactly backwards.

*By distracting their populace from the horrible wreck they've made of the Iranian economy

Nathan Smith

Well, okay. If we take the ideal case of perfectly inelastic supply, it's true that it's impossible to help consumers. Quantity supplied is the same no matter what, and there is only one price that will make consumers demand just that amount. I'd have to know more about the elasticities involved here... Of course, there will be presumably be some elasticity of supply in the *US* market, even if not in the world market, because a higher before-tax price would attract oil from other countries. But if it's a zero-sum game between US and foreign consumers, I'd rather not go there.


Well, I believe transshipment of finished fuel oil is trivial relative to the US market, so we can regard the finite maximum output of US refineries (reached or approached in Summer) as turning the right end of the US supply curve vertical. I'm sure there's more play than that, but it seems (to my limited experience) that there is consensus amongst students of the oil industry that this is close to the truth.

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