I don’t mind the high price of gas these days, not because I don’t drive–I do–but because I think gas ought to be priced this high, and probably even higher. These high prices should reduce the demand for gasoline, and the sooner this happens, the better; the continued unmitigated consumption of cheap fossil fuels could have catastrophic consequences. But, in the long-run demand might not falter; recent research in behavioral economics suggests that supply and demand are not nearly as rigid as was once believed.
The current market for oil is outrageously inefficient because the market participants (buyers and sellers) aren’t paying the full costs of the product, which include externalities (pollution, global warming, etc). As a result, gas is artificially cheap, the demand is artificially high, and we consume more gas than we should. In the end, society must pay the additional costs of these transactions, whether these costs manifest in the form of an emboldened nuclear Iran or more frequent, more severe hurricanes. This is no different than corn subsidies which make corn artificially cheap; with a glut of cheap corn on the market, food companies began researching how to make use of it, and now we have high fructose corn syrup and a diabetes epidemic. And again, society picks up the tab (on both ends). Markets are absolutely fabulous when they’re efficient. Market inefficiencies, however, can have disastrous results.
So the question then is whether the recent gas hikes will reduce demand and begin correcting the inefficiencies in the energy market?According to traditional laws of supply and demand, the answer is an unconditional yes. The prevailing economic opinions echo this affirmation. Consider en excerpt from Thomas Friedman’s op-ed, “9/11 and 4/11:”
“When a person is addicted to crack cocaine, his problem is not that the price of crack is going up. His problem is what that crack addiction is doing to his whole body. The cure is not cheaper crack, which would only perpetuate the addiction and all the problems it is creating. The cure is to break the addiction.” [Emphasis added]
While invoking addiction is appropriate, this metaphor is not quite apt. If we are addicted to oil, then we’re probably willing to pay more for it. Higher cigarette taxes have provided the necessary incentive for some smokers to quit, but quite a few people will keep smoking no matter what the price.
We aren’t addicted to gas, at least not directly. Cheap gas has made a certain automotive-centered lifestyle possible because the cost of driving even significant distances (i.e. long-distance commuting) has been relatively low. This lifestyle profoundly altered the way we planned our cities and towns and suburbs; just compare the East Coast to the West Coast. We are addicted to the lifestyle and services that were made possible by cheap fuel, in this case, fossil fuels. While the days of cheap oil may be behind us, I wouldn’t expect our lifestyle to change substantially because for many people this isn’t simply feasible.
In short term, we’ll consume less by making minor adjustments, like the smoker who cuts back from two-packs a day to one; there is no doubt about this as we’ve already seen this happen. But will higher prices also diminish overall demand in the long run? Keep in mind that to reduce our overall consumption of gasoline, the per capita reduction would have to be drastic since our population is growing and generally become more affluent as well. A 20% reduction per capita will mean nothing.
In his book Predictably Irrational, Dan Ariely, a behavioral economist from MIT & Duke, raises some interesting questions about these traditional economic principles. In the book, he advances the concepts of price anchors and arbitrary coherence. Essentially, Ariely argues that the traditional view of supply and demand is fallacious. In these traditional models, markets achieve maximum utility, or efficiency, by establishing a natural price equilibrium (fair market price) between consumers and suppliers. An inherent assumption of this model is that consumers ‘know’ how much value they place on various commodities; they have inherent preferences. For example, based on our preferences, I might be willing to pay $5 for a cup of coffee, whereas you would only be willing to pay $2 for that same cup of coffee. The aggregation of all these preferences (our willingness-to-pay) at various prices is what constitutes a supply curve. Ariely’s research suggests that this assumption is flawed because we don’t perceive the world in terms of absolute value, and thus don’t have innate preference values.
Ariely builds on work by Daniel Kahnemann (recent Nobel Prize winner for Prospect Theory); Kahnemann has spent his career researching the irrational behavior. He divides cognition into three modes; perception, intuition, and reasoning. Intuition, which drives our market behavior, is a composite of perception and reasoning. Because of the overwhelming amount of information available to our senses (consider all the visual info in your field of vision at this moment), we primarily focus on changes (relative values) rather than absolute values; the same red will be perceived differently when placed next to blue as opposed to mauve.
Ariely posits and experimentally verifies, to a limited degree, that the initial prices we encounter become price anchors, or the base value, from which we perceive change. Once we’ve encountered the price of a product, say a hybrid fruit called oranples, we will judge all future prices of oranples relative to that initial price. Ariely calls this ‘arbitrary coherence’ because prices cohere around an arbitrary initial price rather than at the equilibrium point. (In his book, he shows that using the last two digits of a participant’s social security number as an anchor affects the amount they are willing to pay.) The stunning conclusion is that these anchors rather than our innate preferences determine our future choices. Even if we had valued coffee at $5 a cup (workaday coffee not a triple-mocha arctic frappucino), we would probably be unwilling to pay $4 for coffee since we would perceive that price as exorbitantly expensive, even though the transaction would yield utility in excess of the product’s price. Different theory, same result; less gas consumed. We were used to two-dollar gas so four- and five-dollar gas seems outrageous; we drive less, we sell our SUVs, we buy a fleet of Priuses, so forth and so on.
But Ariely later suggests that increased gas prices my not have this effect. Though he had argued that those initial anchors are powerful determinants of our future behavior, he writes that once our anchors adjust to the new prices, as our memories of the old prices fade–consider how many people gladly pay $5 bucks for a fancy coffee drink from Starbucks, a phenomenom which was unheard of 10 years ago–then we might resume our previous levels of consumption:
The same basic principle [of arbitrary coherence] would also apply if the government one day decided to impose a tax that doubled the price of gasoline. Under conventional economic theory, this should cut demand. But would it? Certainly, people would initially be flabbergasted by the new prices, and so might pull back on their gasoline consumption and mabe even get a hybrid car. But over the long run, and once consumers readjusted to the new price and the new anchors (just as we adjust to the price of Nike sneakers, bottled water, and everything else), our gasoline consumption, at the new price, might in fact get close to the pretax level.
If this is true–and I believe someone ought to be vigorously investigating whether it is–the relevant question is how long would it take consumers to adjust their anchors. If that time horizon is sufficiently long, then it won’t matter whether we’ve adjusted our anchors because we will have already adapted to high gas prices: consumers by purchasing more efficient or alternatively fueled automobiles, corporations by developing alternatives in energy production that are cheaper (both nominally and totally, i.e. including externalities) than energy products derived from fossil fuels.
Additionally, Ariely writes in a (now not so) recent Times column about the unique salience that gasoline prices have in our lives. Conventional wisdom suggests that average citizen reacts strongly to gas price increases because the expense of gas comprises a significant portion of their budgets: apparently some expectant father even agreed to name his unborn son after two radio hosts in exchange for a $100 gas card this summer. In other words, higher gas prices put a strain on household budgets. Ariely argues that this analysis is erroneous. Instead, he posits, gas prices carry disproportionate salience because of the manner in which we purchase gas; standing there watching the numbers rise for several minutes, we feel the price of gas more than say the price of milk [Do you even know the price of milk?]. Sadly though, he suggests that perhaps we should return to full-service pumps so that we wouldn’t feel the expense so deeply. If anything I think we should have a public policy designed to curb our demand for oil and heighten the salience of gas prices; make the numbers bigger and brighter; limit the flowrate of the nozzle so we have to stand there longer. Doing so might generate the (perceived) incentive to change how we meet the needs of our itinerant lifestyle, something we need to do sooner or there might not be a later.
Deliberately upping the price of gasoline at the levels you want would be catastrophic to our economy. This action alone would send our already fragile economy into a tailspin, thousands would lose their jobs as businesses would be forced to cut back due to rising fuel costs and those that did not lose their jobs would not be able to afford food for their families because they would be spending that money on the gasoline needed to get them to work in the morning. It all sounds like a typical liberal plan that peruses an unattainable ideal at the expense of the ordinary person.
In an economic sense I can understand the argument made for passing on what you believe the real cost of production is, but the sad truth is that global warming is anything but a proven fact and should not be factored into the cost of production. The only thing that matters in the costs of production is passing on physically tangible costs (ie. labor, transport, infrastructure) not increasing the cost based on an unproven hunch.
Lets pretend for a moment that global warming is occurring. Allow me to suggest a better strategy: We should let those oil companies use their windfall profits to drill more oil all over the world, lowering the prices and helping the American economy and the average person. During this time we should also pursue alternative energies and focus on reducing their costs to the level competitive with oil and gas. When that time comes, we gradually replace coal and oil with alternative sources. Seems like that would cause a lot less hurt to me.