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01 October 2008


Kevin Cassidy

*This* is the market failure we're going to be talking about? :p

What is the upside of the federally mandated boutique fuels? To your credit, you mentioned air quality, but in a minimizing way.

Following that down the rabbit hole, I have yet to hear a defense of free markets in relation to tragedy-of-the-commons where the concerns are not only resource utilization but common pollution. How would the environment fare with unregulated markets?

Are gasoline supplies discrete enough for the marginal units to work? When I go to a gas station, I fill up. The time cost of making an extra stop versus the chance the price hike is temporary enough to wear off before a few more commutes...this math has never made sense to me. The price hike would have to be as sharp and high as the stated worst-case scenario ($8/gal). Are there studies supporting the point at which people would not fill up?


Great questions. Please do not get me wrong, there are many upsides to boutique fuels. For starters, a system of boutique fuels is much more desirable than mandating a single clean fuel for the entire country. Not only are many boutique fuels more cost effective than one, but the unnecessary costs of a single cleaner fuel are not imposed on areas (mainly rural) that may not need it. While there are additional costs to boutique fuels, these are born by those who also enjoy the benefits of cleaner air. I am not criticizing boutique fuels per se, but noting that their imposition fractures the national gasoline market, which makes it more difficult for the market to withstand supply shocks produced by hurricanes or other difficulties. Normally, the fractured gasoline market functions just fine—producers produce and consumers consume. However, even minor or major disruptions—whether they are caused by a hurricane or a simple pipeline leak—can cause severe price spikes or shortages. The Federal Trade Commission has conducted many investigations into seemingly bizarre spikes in gasoline prices going back three presidential administrations. However, in almost every instance the cause has been a minor problem combined with a boutique fuel. My point is that there is a time and a place for boutique fuels but after a hurricane is not one of them.

Another great question about markets and pollution. Markets cannot function without property rights, and pollution is a problem because no one owns the air (as you pointed out with the Tragedy of the Commons). If someone did own the air, then they could go to court and stop polluters from violating their property rights. If the value created by the polluters was great, then they would pay the owner of the air for the permission to pollute. In this case, not only would pollution result from the highest valued activities, but the polluters would take every step to minimize their pollution (for more on this peep the Wikipedia entry on Ronald Coase). Recent history has shown us that market-based solutions to pollution have been very effective in both limiting pollution, while maximizing value creation to society and minimizing job losses. These market-based solutions have essentially involved getting around the tragedy of the commons by introducing property rights to pollute, either in the form of pollution credits (cap and trade) or a pollution tax (sometimes called a Pigou tax). These have been wildly successful with the exception of the European carbon trading system which collapsed because while everyone was down with the trading part no one really wanted to create a cap. As mentioned, I think market-based solutions to pollution produce superior results at minimum cost. However, I will also point out that the inefficient use of energy is costly. Many firms in this country are eager to replace older equipment with more efficient, less polluting capital. Unfortunately, since the Clean Air Acts “grandfathered” in old equipment, those wanting to replace old equipment with new, more efficient works suddenly find themselves regulated under the costly Clean Air Acts. Once they do the math, they realize that it is cheaper to keep the ancient, inefficient equipment running rather than replace it with something cleaner and greener. This is just another example of the disincentives created by command and control, rather than market-based approaches to regulation.

Your last point is the most interesting a difficult to answer. Gasoline is good that economists classify as inelastic—meaning that demand responds slightly to price increases or decreases (this is due to the fact that we usually have few alternatives to driving and that adjustments, such as folks buying more fuel efficient cars, take time to occur). For example, while gas prices have doubled in the last few years, quantity demanded in the U.S. has only decreased by about five or so percent. If gasoline was a good with a neutral elasticity of one, then a doubling of price would result in a halving of quantity demanded. However, most studies estimate that the elasticity of gasoline is about .2, meaning that a halving of quantity demanded would require an increase in price of perhaps five times. At the same time, this means that even slight increases in supply would result in dramatic reduction is price. This is why the addition of a couple of million barrels of oil production would have a considerable impact on the price of oil. The $8 a gallon was an arbitrary number that I threw up, but you make a good point about the opportunity cost to you in stopping to fill up. I guess the best answer is to give a personal example. I drive relatively little, and (prior to this situation) was only adding five or so gallons at a time, but I now keep my tank very full, because I worry that I may not be able to find gas when I need it (as I did when I found myself back from a business trip two weeks ago and banging on empty). If gas was $8 a gallon, then I might re-evaluate my opportunity cost for stopping and also consider that adding some more gas later will appear on my credit card bill next month rather than this month. I guess the last point to make is that people fill up when they are uncertain. For example, during the gasoline difficulties of the early and late 70s, folks went from keeping their tanks an average of a quarter full to more than a half a tank (true, there were shortages, but people kept on topping off). So what would be peoples’ behaviour if they saw $8 a gallon gas, but also saw that all the stations had gas? In this case they would probably be less inclined to “speculation” (as in filling the whole tank) and more likely take just a few gallons at a time to tide them over until the inevitable restoration of supplies.
Anyway, I will look to dig up some studies for you, but I have written too much already. Please let me know if this answers your questions.

Kevin Cassidy

Thank you for the well-reasoned, comprehensive response. I've vaguely heard of Coasian economics over the last few years, this gives me an excellent starting point for personal study.

And now I've heard a good free market-environment defense. Well done!


James k Saylor


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