Monday, July 4, 2011

President Obama and Regulation vs. Pricing

I opened my New York Times this morning to see that President Obama wants to raise fuel economy standards by twofold over the next 14 years.  I have no doubt that the goal of reducing fuel consumption is a good one, but doing it using regulation is clumsy and could be counterproductive.

First, such regulations could hurt welfare in three ways: if it drives up production costs, it will reduce the number of cars sold and hence have an adverse impact on employment.  Second, it could lead to cars that people don't want, and so consumer welfare is reduced.  Third, if cars get high mileage, people will drive them more--not enough, in all likelihood, for total fuel consumption to go up, but enough to create other negative externalities, such as congestion.

But what of the fact that fuel consumption produces negative externalities?  That it leads to greenhouse gas emissions and  endangers our security?  The best way to deal with a negative externality is to impose a Pigou tax--one that requires consumers to pay for both the private and social costs of their actions.  If the US had gas prices more similar to what we observe in other parts of the developed world, it is likely that people would generally choose more fuel efficient cars, but that those who wanted big cars even in the face of higher gas prices would be able to buy them.  At the same time, such a policy would discourage driving (better fuel economy encourages driving), and would therefore help relieve congestion a bit.  The revenue raised by a gas tax could also be used to fund transit and provide a tax cut to those most hurt by higher gas prices--those at the lower end of the income distribution.