Greg Mankiw’s seventh principle of economics is that “governments can sometimes improve market outcomes.” Modifying “can” with “sometimes” is common economic analysis built on tons of experience. The production and consumption of oil exemplifies the problems that even government with the best of intentions faces. We often associate oil production and consumption with two market failures: market power and negative externalities (pollution), and they are partially offsetting. A government response to market power is to create more competition which would increase output, decrease price, and increase the negative externalities. A government response to negative externalities is to impose a tax that would decrease production and consumption and drive up prices.
The issue of oil production and consumption is more complex still. Oil, and the products derived from it, add greatly to our national wealth. At present, it does not have good substitutes. In addition to directly creating wealth, it also creates positive externalities as do all market based transactions. Because it is the cheapest form of energy for many uses, someone else’s use of oil benefits me because its consumptions leaves them wealthier and more able to buy the goods and services that I produce. We know that steeply rising oil prices can act stop economic growth or even throw it into reverse. (HT Drudge Report) That is why our eyes are on OPEC as the price per barrel of crude oil approaches $100 (Gene Ramos, “Oil off on U.S. data but OPEC eyed as $100 in sight”).
Mankiw’s sixth principle is that “markets are usually a good way to organize economic activity.” How do markets help? In response to higher prices, consumers will shift consumption to energy efficient products. Companies that make products that are not energy efficient will lose business unless they can modify their products to use less energy. Markets even help solve market failures. Pollution is often a sign of inefficient production. Learning from BP’s example, oil companies will be more careful when drilling, not just to avoid cleanup costs, but to not waste a valuable resource. The internal combustion engine has grown more efficient in part by polluting less. A fuel efficient car in 1972 got about 25 miles per gallon on the highway, less than most modern minivans. Firms exercising market power by withholding product to raise prices will face new competition from firms that want to grab part of the high profit market power creates. Schumpeter referred to innovation threatening existing producers as the “winds of creative destructions.” Are these winds sufficient to blow away oil’s twin market failures of market power and negative externalities?