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Some important topics: The oil premium Economics 331b

Some important topics: The oil premium Economics 331b. Sources of the Oil Premium. Monopsony premium (pecuniary, affects oil expenditures)* Macroeconomic externality (inflation and unemployment in Keynesian world)* Global warming externality from CO 2 (later in course)*

cassandra-romanos
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Some important topics: The oil premium Economics 331b

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  1. Some important topics: The oil premium Economics 331b

  2. Sources of the Oil Premium Monopsony premium (pecuniary, affects oil expenditures)* Macroeconomic externality (inflation and unemployment in Keynesian world)* Global warming externality from CO2 (later in course)* Road safety (regulation, insurance, liability laws) Economic losses from disruptions (tough to estimate) Military costs (tough to estimate) Pollution (by air and other regulations) Congestion (generally ignored, but could use congestion pricing) * Covered today or later in the course.

  3. Basic calculation of the premium The “oil premium” refers to the excess of the social marginal cost of oil consumption over the private marginal cost. Analytically, this is

  4. The monopsony premium P, MC of oil MSC S Import premium at free-market imports “Optimal Tariff” at Optimized oil imports D Imported oil 4 Q(“optimal”) Q(free market) 4

  5. Example World supply = Q0 = 100 World supply elasticity = 1 US demand = 20 (inelastic) Price = P0 = $100 Now increase US demand by 1 unit. Increase in price = $1 Increase US demand 1 unit or 5 percent. US supply elasticity = λ = 5 Marginal cost = (Q1 P1 - Q0 P0 ) = (21*101 – 20*100) = 121 = P(1+ 1/λ)

  6. Optimal tariff (monopsony) reasoning on oil taxes Basic argument. 1. The point is consumers have market power in the world oil market. By levying tariffs, consumers can change the terms of trade (oil prices) in their favor. 2. Regulation and taxes are a substitute for the optimum tariff. Simple reasoning: • world supply curve to US: Q = Bpλ , λ>0; so p=kQ1/λ • US cost of imported oil = V(Q) = pQ = kQ(1+1/ λ) (k an irrelevant constant) • marginal cost of imported oil = V’(Q) = (1+1/λ) kQ1/ λ= p (1+1/ λ) So optimal ad valorem tariff is : τ = 1/ λ = inverse elasticity of supply of imports Reference: D. R. Bohi and W. D. Montgomery, “Social Cost of Imported Oil and UU Import Policy,” Annual Review of Energy, 1982, 7, 37-60.

  7. Optimal tariff argument (continued) Complications: This is oversimplified in bathtub model. Formula actually is

  8. Optimal tariff argument (continued) Some notes: • Supply elasticity depends critically on whether oil market is at full capacity (2007 v. 2009). Very inelastic in full capacity short run; quite elastic when OPEC adjusts supply. • The optimal tariff in $ terms depends upon the initial price because it is an ad valorem tariff. • The externality is a global externality for consuming countries because it is a globalized market (in bathtub world). • Note this is a pecuniary, not a technological externality. So it is a zero-sum (or slightly negative-sum) game for the world. This has serious strategic implications and suggest that the diplomacy of the oil-price externality is completely different from true global public goods like global warming. • This does not have to be a tariff. It is really a “shadow price” on oil imports. • This is an example of “Ramsey tax theory” with inverse elasticity formula.

  9. The monopsony premium differs greatly depending upon the state of the world oil market. Price Short-run production capacity Production

  10. Basics of deriving oil (monopsony) premium Here is a more rigorous proof of the oil-import premium:

  11. Numerical example for US

  12. Macroeconomic externality Somewhat more tenuous is the macroeconomic externality. Idea is that there are impacts of changes in oil prices on macro economy because of inflexible wages and prices. So have another linkage: The second term was discussed in optimal tariff. The first term comes from macroeconomics (see next slide). This, however, is very controversial and the estimates are not robust.

  13. Macroeconomic externality (cont) Simplified derivation: We can also derive that monopsony/macro = ε[GDP/pQ] = .017*(15000/450) = .56

  14. Macroeconomic externality (cont) A standard macro/oil-price equation with “good” results.

  15. Updated estimates* P0 Paul N. Leiby, “Estimating the Energy Security Benefits of Reduced U.S. Oil Imports,” ORNL, 2007. Note added after class: The 2006 results are for 2006 oil prices, which were about $55 per barrel. So the premium is about 25% of the price.

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