Econ 101: How to Reduce Gas Consumption

     President Bush announced in his State of the Union address that Americans should reduce gasoline usage by 20 percent over the next 10 years. But how will this be achieved?

With or without government

     In 1931 Harold Hotelling published a paper, “The Economics of Exhaustible Resources,” that showed that the market process efficiently allocates the exploitation of a non-renewable resource over time. His basic point is that as the supply of a resource shrinks, the price begins to rise.

     That leads to an effect on the demand side. As the price of oil rises, people will use less oil. Automakers will make cars that get better gas mileage, as these will be cheaper to operate and attract more customers. People will further insulate their homes, as the energy cost savings will now exceed the cost of the insulation. Some people will move closer to their jobs; others will purchase fewer airline tickets, and so on. The demand for oil is, like any other product or service, downward sloping, so people buy less at higher prices and more at lower prices.

     It is no wonder that the amount of known reserves remains relatively constant in the face of increased usage of oil. This is because it is costly to seek out reserves. Only when the price of oil is rising is it worthwhile to spend money finding new reserves. There is also a greater incentive to innovate in energy substitutes. Synthetic oil for cars, the use of ethanol, solar power cells, and other inventions will occur more rapidly as the return for discovering and producing them increases with rising oil prices.

     All of those things would happen naturally as the market reacted to costlier oil. But when government begins to interfere in the system, inefficiencies occur.

Taxing “windfall profits” of oil companies reduces the incentive to find and refine more oil. It also reduces the incentives of oil companies to innovate and find alternative sources of energy.

Price controls merely cause shortages. Government actions, or the potential for them, create uncertainty in the market. When uncertainty is injected into the system, there is more risk for the innovator and producer, so fewer projects will be undertaken. Firms begin to spend resources trying to affect the political outcome, rather than making new discoveries and producing additional product.

Taxes & subsidies: Once the government is going to impose huge taxes on some behavior and provide tax breaks or subsidies for other behavior, an incentive is created to lobby the Congress to get a break for your particular company or to subsidize the method you employ. Businesses will attempt to find alternative energy sources that are politically favorable rather than economically efficient.

‘Energy security’

     One might make the argument that we are "too dependent on foreign oil" for our security needs. This argument presumes that 218 members of the House and 51 Senators know what the proper level of dependence on foreign oil is for our national security. This is a rather tall order.

     The reality is that the political process will decide such a thing, meaning that lobbyists for the windmill industry, the solar power industry, the coal gasification industry, the agricultural industry, and assorted other industries will attempt to convince the Congress to provide benefits for them and restrict the output of their competitors, all under the guise of national security.

     Markets are very dynamic. They respond quickly to changes in consumer demand and input changes. That is one reason the Soviet Union is gone and Ireland is one of the fastest-growing countries in the world. It is difficult to believe that a security threat to the oil fields would not be met with all sorts of inventions and changes in behavior that would lead to a market solution to the problem.

     It is also unlikely that foreigners who own the oil would attempt to disrupt the economic activity of their largest customers. Foreign governments that hold large oil reserves realize that any economic and political power they have is tied to demand for oil. Suddenly withholding oil would result in their oil being seen as uncertain and the long-term demand for their product dissolving, along with their tax revenue and their political clout.

     An obvious solution to the lack of certainty in Iraqi oil is to take the oil out of the hands of the government, give it to newly formed oil companies and give each Iraqi citizen shares in these oil companies. Once the average Iraqi has 100 shares in the oil company, he will take a dim view of his neighbor blowing up the oil pipeline.

     The interconnection of commerce makes good neighbors. Iraqis will see that their fortune depends upon economic growth in the United States and Western Europe. The incentives of the system will have drastically changed. The solution to our oil security problem is less government intervention, not more.

Dr. Gary L. Wolfram is the George Munson Professor of political economy at Hillsdale College in Hillsdale, Mich. He also serves as an adviser to the Business & Media Institute.