Question

Some observers have argued that importing oil makes the United States hostage to the policies of Saudi Arabia and other countries in the Middle East. This complicates US foreign policy.

a. Explain why an externality is present in this situation.

b. Propose a Pigouvian tax to deal with the externality.

c. Some economists want to curb domestic gasoline consumption but are wary of giving the government substantially more revenues than it already has. As an alternative, Feldstein [ 2006b, p. A10] suggested a system of tradable gasoline rights ( TGR): “

In a system of tradable gasoline rights, the government would give each adult a TGR debit card. The gasoline pumps at service stations that now read credit cards and debit cards would be modified to read these new TGR debit cards as well. Buying a gallon of gasoline would require using up one tradable gasoline right as well as paying money. The government would decide how many gallons of gasoline should be consumed per year and would give out that total number of TGRs. In 2006, Americans will buy about 110 billion gallons of gasoline. . . . To reduce total consumption by 5%, [government] would cut the number of TGRs to 104.5 billion.” Draw a diagram to illustrate how the price of the tradable gasoline rights would be determined. Suppose that the market price per voucher were 75 cents. How would this change the opportunity cost of buying a gallon of gasoline?

Answer 1

a.      The price of imported oil does not reflect the increased political risk by effectively subsidizing authoritarian regimes like those in Saudi Arabia. 

b.      The tax would estimate the marginal damage (e.g., the increased instability in the Middle East, etc.) by importing oil from Saudi Arabia.

c.      The supply of TGRs is vertical at 104.5 billion if government seeks to reduce consumption of gasoline to 104.5 billion. Consumers must have one TGR in order to buy one gallon of gasoline, plus they must pay the price at the pump. Limiting TGRs effectively limits the demand for gasoline, so the price per gallon will fall, but consumers must have TGRs in order to purchase gasoline. If the market price of one TGR is $0.75, this means that supply and demand intersect at $0.75, as shown in the graph. This kind of program curbs consumption without giving government more revenue because consumers are purchasing the TGRs from each other. However, the total amount of TGRs is limited by government. Those consumers seeking to purchase more gasoline than allowed by the initial allocation of TGRs can purchase additional TGRs from other consumers at the market price of $0.75. By choosing to use a TGR to purchase gasoline, a consumer incurs an opportunity cost equal to $0.75 since they cannot sell the TGR once it has been used.