The Daily Background

One Response to “The solution to gas prices…”

1. Steve, on May 7th, 2006 at 12:56 am Said:

   Gas now costs $3 per-gallon. The policy response coming out of Washington DC to this ranges from pathetic ($100 rebate) to bad (suspension of the gas tax) to even worse (price controls). Fortunately, there are policy options available to the US that are infinitely superior to those currently being considered. These options would not only exert downward pressure on gas prices, but also put money in people’s pockets, while reducing traffic congestion, global and local air pollution, and road and parking costs. In addition, all this can be achieved without raising taxes, increasing the budget deficit, building new refineries or drilling in environmentally sensitive areas.

   This combination of benefits can be achieved because the US transportation sector is enormously inefficient in economic terms. In many respects, the transportation sector is the “Soviet Union” of the US economy, regularly violating the fundamental micro-economic principle that the price paid for a good or service should vary with the costs of producing it. More than half the total cost of driving is either external (meaning that the cost is paid for by someone other than the motorist) or internal but fixed (meaning that the motorist pays the same price regardless of how much he/she drives).

   Neither external nor internal fixed costs are reflected in the price of driving, giving motorists a faulty signal to drive more than they would otherwise. Some low-benefit driving is therefore inefficient in the economic sense because the actual cost of producing this “marginal” travel is greater than the benefit (or, to put it differently, more than what the driver would be willing to pay for it, if he/she were paying full freight). Overall, we would be better off if this marginal travel were not produced and consumed, and the savings spent on other goods and services of greater benefit. Incorporating external costs and internal fixed costs into the price of driving gives motorists market signals that encourage efficient behavior.

   External costs can be included in the price of driving through what are known in economics as “corrective” taxes. This is the justification of seemingly exorbitant gas taxes paid by drivers almost everywhere outside the US. There is widespread consensus among economists of all ideological stripes that higher gas taxes in the US are justified on efficiency grounds. The problem is political: higher gas taxes mean higher prices at the pump for already outraged driver/voters.

   On the other hand, incorporating internal fixed costs into the price of driving can increase efficiency without inciting political opposition because drivers already pay for them. When these internal fixed costs are converted to variable costs, all drivers enjoy incentives to reduce driving of minimal benefit. As a result, aggregate miles traveled and gasoline demand decline, putting downward pressure on gas prices. In addition, motorists who do reduce their driving get to pocket the cost savings that result.

   This situation is analogous to flat-rate water use fees. If consumers pay by the year and not for the amount of water used, no one faces any incentive to fix leaky faucets, to sweep the driveway instead of hosing it down, or to avoid over-watering the lawn. As a result, everyone’s water usage goes up and aggregate consumption goes way up, along with water rates. When fees are changed to per-gallon basis, everyone has an incentive to use less resulting in lower water consumption and prices.

   There are two areas in the transportation sector where internal fixed costs can be converted to more efficient variable costs: auto insurance and “free” employee parking at work.

   Currently, car insurance is a fixed internal cost, sold on an “all you can drive” per year basis. William Vickery, who was awarded the Nobel Prize for Economics in 1996, proposed an alternative which bases premiums on miles driven in addition to existing rate factors such as age, gender, DUIs, accident history, location of residence, credit score, etc. Within any rating class, the less you drive the more you save, so every driver enjoys an incentive to reduce the number of miles they travel. Each driver decides which miles provide the least benefit and can be reduced with minimal pain, while preserving the option of driving when the perceived benefit is great.

   “Free” employee parking at work is similarly a fixed internal cost, although mostly invisible to the employee. Currently the compensation package for almost all US workers includes “free” parking at work. Of course, providing this parking is not free but has a cost of $50-100/month that reduces the employee’s take-home pay. Effectively, the employee pays for his parking spot regardless of whether he drives and parks or not. The solution to this distortion is Parking Cash-Out. This means that commuters who are offered subsidized parking are also offered the cash equivalent if they use alternative travel modes. Each commuter decides how to get to work, but those who choose to walk, bike, carpool or ride transit can now pocket the parking cost savings that occur.

   Just how big are the effects of these two proposals? It is estimated that a 6-cent per-mile auto insurance incentive would reduce total miles traveled by roughly 10%, while Parking Cash-Out typically reduces automobile work commuting by 10-30%

   The beauty of these proposals is that they are truly “win-win”, in that the increase in efficiency and consumer welfare is truly a net economic benefit, not merely a transfer from one group in the economy to another. In addition to reducing the price of gasoline, these proposals would also benefit motorists and non-motorists alike in numerous ways: Collision costs, injuries and deaths would be reduced because all drivers would be traveling less and getting in fewer accidents, and crash-prone drivers would face particularly high per-mile incentives to reduce their mileage. Car ownership would be more affordable, as insurance is converted from an ownership cost to an operating cost. There would be less traffic congestion (especially at rush hour due to Parking Cash-Out), less global and local air pollution, and reduced road and parking costs. Low-income drivers would be able to purchase only as much insurance as they need, no longer forced to choose between driving uninsured and buying prohibitively expensive unlimited–mileage coverage.

   Instead of wringing our hands about high gas prices, looking for foreign and domestic scapegoats, and mortgaging our kids’ future so we can maintain our wasteful driving habits just a little longer, we should get to work on solutions that reduce the market distorting inefficiency of our transportation sector.

Leave a Reply