No, this isn’t going to be a political rant about the war in Iraq, or our dependence on (foreign) oil. I want to look at the price of gas, and tackle the assertion that gas prices are too high, and that high gas prices are a bad thing.

We often complain that we (Canadians, but also Americans) are paying too much for gasoline. The reality is, what we pay is a small amount compared to what the rest of the world pays for the same thing. Because we extract and refine a lot of our oil right here in Canada (as well as placing relatively small taxes on gasoline), we can afford to keep our gas prices relatively low, even with our burgeoning consumption. However, the price of gas at present doesn’t really tell us what the price should be.

Is the price of gas too high?

From an economist’s perspective, the cost of gas is still too low. This mainly arises from the fact that when pricing gas, we fail to take into account the externalities associated with gas consumption. The most popular externality nowadays is the pollution (and carbon emissions) that result from the burning of gasoline. However, as pointed out in this article by Stephen Dubner and Steven Levitt (authors of Freakonomics), the much larger externalities of damages and lost time caused by congestion on our roads is just as problematic. Until we start considering these factors, the price of gas will always be too low to provide a proper market equilibrium. From the perspective of an economist, we would be better off if the price of gas were to rise even more (and ideally, by taxing gas (in one way or another) in order to internalize the externalities.

But does this translate into an optimal social policy? The rising price of gas is already straining commuters’ budgets, and is raising the price of food across the country. The newfound difficulties in driving to work may be an unpleasant prospect to some people, but it remains far from an insurmountable obstacle to getting to work (barring some political issues with public transit, especially here in Toronto). Those who still really want to drive to work can find some way to work it into their budgets.

By far, the biggest problem associated with rising gas prices is the cost of transporting food, materials and equipment. At first, raising the cost of food might seem like a bad idea. In the coming years, everybody will find themselves spending more of a percentage of their budgets on food. People will have to re-work their budgets, and they may find themselves spending more on food than they want to (and more than they used to), but the fact remains that if we want people to make correct and informed decisions regarding food purchases, these decisions have to be based on the real costs of the food.

Ultimately, the sentiment that we are “spending too much on gas” is incorrect. The supply and demand of gas, as well as a whole host of other factors (political, environmental, etc.) determines what we spend on gas. It is important that we realize the true value of gas, and by extension, the true value of all things manufactured or produced with gas/oil, in order to understand the impact our consumption has, as well as to ensure that our consumption remains at a sustainable level.

Peak Oil and Market Economics

One of the things that market economies do exceptionally well is adapt to new and changing situations. The rising price of gas is important, because it serves as an economic indicator that oil is becoming a scarce resource, and that we won’t be able to supply enough to meet the present demand in perpetuity. The rising cost of gas not only drives innovation in the field of alternative forms of energy in the hopes of finding a new fuel source that can offset the cost of rising gas prices, but it also makes it possible to invest in other forms of energy production that were previously ineffective due to their cost. Just like the tar sands in Alberta became a viable method of oil production once the price of oil rose enough to make the extraction process worthwhile, so too will other forms of energy - like nuclear, solar and wind - as the cost of oil continues to rise. Additionally, as these technologies merge into the mainstream, they are likely to become more efficient and cheaper.

Nobody likes spending more money than they have to on something; especially if that something is as important as gas. However, rising gas prices are both a sign of a healthy and functioning market economy, as well as a necessity to drive innovation and ensure a balanced equilibrium of fuel production and consumption. The abundance of oil and our efficiency of its utilization up to this point, has kept oil and gas prices relatively low. However, all of that’s about to change; and the faster gas prices rise, the sooner we’ll be tossing away our internal combustion engines for electric cars. It’s time for oil to step out of the spotlight, and give some other sources of energy a shot.

Update: I found this article on marketwatch.com; it makes some similar points.