Reducing the U.S. vulnerability to oil supply shocks: comment.

Tower, Edward

I. Introduction

Recently in this journal Mine K. Yucel [2] evaluated alternative ways to reduce U.S. vulnerability to oil supply shocks. As her measure of vulnerability she uses the change in the aggregate welfare of U.S. consumers and producers due to a proportional increase in the word price of oil. She considered a specific import tariff on oil, a gasoline tax and a drawdown of stocks from the strategic petroleum reserve. She concludes [2, 309] that

the tariff decreases vulnerability if the short-run oil supply elasticity is low, but increases vulnerability if the short-run supply elasticity is more than 1.0. The gasoline tax, on the other hand, increases vulnerability if short-run supply is very inelastic, but decreases vulnerability if elasticity is higher than 0.5. However, in the event of a supply disruption, short-run elasticities could be very high. A governmental drawdown of oil from the SPR as happened during the most recent crisis would substantially increase short-run elasticities. Then, the gasoline tax along with an SPR drawdown would be the best weapon against supply disruptions.

II. An Import Tariff Is Likely to Increase Consumer Vulnerability to Foreign Oil Price Shocks

Dr. Yucel's result that an import tariff may increase rather than decrease vulnerability to a foreign price shock, is an intriguing point, which deserves additional attention. To see this in its simplest manifestation, assume a single period, no domestic production, an advalorem import tariff (rather than the specific one that the author uses), and assume the tariff revenue doesn't enter into the welfare calculus, as the author does (perhaps because it is wastefully spent by a kleptocracy). For a small price change, the welfare cost to consumers is the increase in price times initial imports, which equals the proportional increase in consumer price times initial spending on the import. Since initial spending on the import increases with the tariff if the demand for the import is less than unitary elastic, inelasticity of the demand curve is the condition for vulnerability to increase with the tariff.

Dr. Yucel assumes a long run elasticity of demand for oil of 0.9 and a short run elasticity which is smaller than that. She finds that the tariff will lower vulnerability if and only if the supply elasticity is greater than a critical value. Had she used an ad valorem import tariff instead of a specific one, had she performed a single period analysis and had she used the welfare impact on consumers, she would have found that the import tariff necessarily increases vulnerability. Would it make sense to use an ad valorem tariff rather than a specific one? Yes, because an ad valorem tariff faces the monopolistic foreign supplier with a flatter demand curve, and may induce him to lower his price [1]. Does it make sense to focus on the loss of consumer welfare? Yes, because that is likely to be the focus of the political pressure for independence from foreign price jumps. Moreover, some of the domestic oil industry is foreign owned. We conclude that an oil import tariff is likely to increase the vulnerability of consumers.

III. The Approach to Cost Benefit Analysis

Now, I would like to suggest an alternative structure for the cost/benefit analysis. Dr. Yucel's methodology is to impose a policy, e.g. free trade, a tariff or a tax, and then calculate the present value of the welfare loss of a supply disruption with that policy in place. That is her measure of vulnerability under the policy. By this measure the vulnerability to an oil shock of an autarkic U.S. would be zero. Similarly the vulnerability of a corpse to a heart attack would be zero. On the basis of the author's criterion of advocating lowest vulnerability policies, we should encourage suicide! Suppose our concern is to minimize potential loss from the disruption plus the by-product loss from the policy designed to mitigate it. Then we find the best policy by maximizing, [B.sub.t], which is welfare under the supply disruption and the policy in question (e.g., the tax) minus the welfare under the supply disruption and a benchmark policy (e.g., free trade). A more general cost/benefit approach would be to pick the policy which maximizes expected welfare. Let P be the probability of a supply disruption. Let [C.sub.t] be the cost of the policy if there is no supply disruption. Then, we could maximize the expected net benefit of the policy: [B.sub.t]P - [[C.sub.t]][1 - P].

Had we modeled the U.S. as a small economy, focussed on aggregate welfare to all domestic agents and assumed all home oil as domestically owned, we would have found an additional cost of the tariff using this approach. Recognizing the partial foreign ownership of the U.S. oil industry makes the tariff less desirable. Recognizing that the U.S. is not small in the world oil market and modeling OPEC as a Stackelberg follower who perceives the US tariff as given make the tariff more desirable [1].

IV. Suggestion

The author's methodology would be admirably suited to perform alternative calculations along the lines suggested above.

Specifically, I would be intrigued to see calculations of the optimum tariff and gasoline tax. My expectation is that a substantially positive oil tariff will be optimal even in the absence of a supply disruption, since OPEC is modeled as a monopoly. The same reason should yield a positive gasoline tax, but I would expect it to be smaller, because it distorts the allocation of petroleum between alternative uses in the American market.

I would also be curious to see under a supply disruption the effect of the tax and the tariff on the welfare of consumers. These calculations would drive home the message that in the context of the author's model national welfare is served by the tax (up to a point) but unless tax and tariff revenue is redistributed and unless consumers are shareholders in oil companies consumer welfare is hurt.

Edward Tower Duke University Durham, North Carolina and The University of Auckland Auckland, New Zealand

Thanks go to Omer Gokcekus and Kent Kimbrough for helpful comments.

References

1. Tower, Edward, "Making the Best Use of Trade Restrictions in the Presence of Foreign Market Power." Journal of International Economics, November 1983, 456-73.

2. Yucel, Mine K., "Reducing U.S. Vulnerability to Oil Supply Shocks." Southern Economic Journal, October 1994, 302-10.