Tuesday, April 18, 2006

How High A Priority?

A comment on yesterday's posting concerning hybrid cars and ways to encourage fuel efficiency started a train of thought that seems worth a posting of its own. We talk a lot about wanting to reduce our oil consumption and imports. In support of this, we cite geopolitical concerns and local and global environmental issues. Rarely, though, do we attach a value to this desire or attempt to prioritize it relative to other issues. High fuel prices elicit so many consumer complaints--I was subjected to a barrage of them at a family Easter celebration over the weekend--because gasoline is central to so much of what we do. Then why is it that, when we talk about reducing our oil consumption, we usually neglect to tally up the economic consequences of using less of this vital input? The leverage effect of energy in our economy creates great potential for unintended and disproportionate consequences of policy in this area.

This is something that doesn't get nearly enough attention, though it's neither as obvious or trivial as it might seem at first. Nor is it a way to rationalize irresponsible consumption, as some might suggest. I'm quite prepared to accept that there's a fair amount of waste involved, in terms of unnecessary travel that could be consolidated or eliminated. Most of the time, however, when people drive somewhere it is to do something, whether it's work, shopping, or something else that generates economic activity. We need to be careful when cutting fuel consumption that we don't eliminate the economic value it generates.

There are three main ways to reduce fuel consumption: 1) maintain presents cars so as to maximize their fuel economy, 2) buy more efficient vehicles, and 3) change behavior and patterns to drive present vehicles less far and/or less often. Of these, the first is the easiest all around; it costs little and harms no one. The second is more difficult. Only about 7% of the cars on the road are replaced in any year, despite chronic overcapacity in the car industry. Buying a more efficient car is great for the economy, and increases your fuel economy immediately, but chances are your old car didn't get sent to a crusher, so it's still around burning gas, too.

The third option is potentially the most trouble for the economy. Whether voluntarily or as a result of government-sponsored incentives or penalties, driving less to save gas risks reducing GDP, and I'm not just talking about the earnings of oil companies. To see why that's so, think back to Econ 101. We tend to consume things up to the point at which their marginal benefit equals their marginal cost. So that extra trip in the car was worth at least as much to the person who took it as the marginal cost of doing it. In fact, it was worth much more, because the cost of operating a car goes well beyond fuel.

If you take an average car getting 25 miles per gallon, gas at $3.00/gallon makes up only 27% of the 44.5 cents per mile operating cost, using the 2006 IRS mileage allowance as a proxy for fleet average operating cost. That means that even if the time required for the trip had zero value, the cost of that marginal one-gallon trip--and thus its marginal benefit--would equate to about $11.00 on a gallon-equivalent basis. (I realize that marginal costs are likely to be lower than average costs and would welcome any comments providing a better approximation for this.)

So in simple terms, saving $3.00 worth of gas could cost the economy another $8.00 in GDP somewhere outside the petroleum value chain. If the goal were backing out 1 million barrels per day of imported oil, about 5% of our consumption or 10% of imports, that would save the US about $25 billion a year at current prices. But it could also reduce GDP by something like $120 billion/year, using the above estimate. If that sounds high, remember that saving a million barrels per day of oil means cutting energy consumption by about two quadrillion BTUs/year, or about 2% of the total energy consumption of a $12 trillion economy. That has to have costs, as well as benefits.

Where does that leave us, if it will take decades to replace our present car fleet with a much more efficient one, and if immediate, behavior-driven changes in fuel consumption risk damaging the economy? I don't take this as evidence that we can't do anything, or that sensible conservation is bad, and it certainly doesn't justify someone buying a 7,000 lb. SUV getting 12 miles per gallon on the basis that this will create some wonderful ripple effect in the economy.

Rather, I believe the logical conclusion to draw is that wholesale measures to dampen fuel use--and in that I include any substantial increase in gasoline taxes--ought to be undertaken only after the most thorough analysis, going far beyond the fuel sector, and that targeted incentives are likely to be more cost-effective, overall, than across-the-board measures. It also says we need to be very clear about where reducing oil consumption fits in the overall hierarchy of our priorities, including economic growth, balances of trade and payments, international relationships, and environmental stewardship. Setting priorities is really the first priority of leadership, isn't it?

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