There are many possible reasons for suspecting market failure in a product like gasoline. Throughout the world, the exploration, refining, and selling of petroleum products has long been controlled by large firms in oligopolistic or monopolized national markets. The United States is a sufficiently large importer of oil that it could have monopsony power, which would mean that we could increase the welfare of our own citizens by reducing our imports. Moreover, the consumption of petroleum products, especially in motor vehicles, generates many negative external costs, and will begin to examine closely in the next chapter. Where there are negative externalities, a free market will overproduce and over consume.
Market failure may also emanate from the fact that fossil fuels are nonrenewable resources, which means that the optimal rate of exploitation is very sensitive to the interest (discount) rate and to knowledge about remaining reserves and Alternative Energy Future. Private firms might apply too high a discount rate, which would lead them to extract and exhaust the resource too rapidly. And it is possible to argue that governments might have better knowledge about reserves and alternatives and that this knowledge urges a different rate of utilization of those reserves than a private market would bring about.
But the U.S. government did not concern itself with reducing gasoline consumption until the mid-1970s, and all the preceding arguments existed long before then—except for one. When OPEC began to utilize its cartel power in 1973, it added a new element of monopoly to a market already fraught with monopolistic elements at the exploring, refining, and selling stages. Monopolies, however, do not necessarily extract nonrenewable resources too rapidly. On the contrary, facing a downward-sloped straight-line demand curve, a monopoly exploits its power by extracting the resource too slowly so that the current price is kept above competitive levels. A by-product of this too-high price is that the time over which the resource is utilized is stretched out, and the conversion to alternatively fueled vehicles would be made too late, not forced too early, from a social viewpoint.
There remains only one plausible reason for the sudden determination of the U.S. government in the 1970s to reduce American use of petroleum. The exercise of OPEC control over oil production—and the OPEC countries then owned nearly 90% of the world’s known oil reserves—made it clear to American policy-makers that the U.S. economy, powered by fossil fuels, was now hostage to foreign governments’ decisions. We had become vulnerable—to use a phrase popular in the 1970s, we were “heavily dependent upon uncertain foreign oil sources.”
This dependence added a perceived new external cost to gasoline consumption: the more oil we consumed, and hence the more oil we had to import, the more we as a society either had to endure risk of deprivation or had to devote additional resources to our, and our allies’, military strength so that we could forcibly prevent such deprivation if it were threatened. Some see evidence of this in our spending an average of an additional $15 billio a year over the last decade or two on this account. Indeed, we spent over $50 billion in 1990 on “Operation Desert Storm” to free Kuwait from an invader that did in fact threaten our continued oil supplies. If these costs had been “internalized” into gasoline prices over the past decade, it would have required an additional gasoline tax of something up to possibly $0.60 per gallon throughout the period.
We have been spending more money in the Middle East because of our dependence on the oil there. Almost everybody agrees on that. What is at question is whether we need to spend more money in order to ensure our continued supply of oil. Most economic research says no, concluding that OPEC is at best a “clumsy cartel”. It would be hard for any oil-exporting country, or group of countries, to stop oil imports into the United States without stopping their exports to countries that would happily redirect the oil to us. And if these countries ceased exporting oil altogether, with what would they pay for their imports?
Suppose, however, that OPEC did succeed in stopping oil shipments to the United States, even trans-shipments from other countries. The price of oil and oil prices inflation would rise dramatically in the United States. There would be huge profits available to OPEC members who defected from the oil sanction, either overtly leaving OPEC or covertly shipping oil anyway.
