Monday, August 29, 2005

Expected Future Oil Prices and Activist Government Policy

Everyone knows that expectations play a key role in economic life. If I expect to live to be 100 years old, I save more than if I expect to live to age 45. How do people and firms form expectations over the future price of oil? If people expect that the price of oil will stay or rise above $3 per gallon, we all agree that buyers will demand "greener" vehicles and producers would invest more in green R&D to develop such vehicles.

Economists such as Manski of Northwestern have been working on methods to elicit individual's subjective guesses about future unknown events. For example, we'd each love to know what the price of oil will be in the year 2008. Suppose that today 65% of car drivers thought that the real price of oil will be above $4 per gallon. This "fat right tail" of the distribution would create demand today for green car purchases between now and the year 2008.

In a recent posting, I discussed a moral hazard problem that may or may not be true. If people today believe that government will step in and take activist steps to "guarantee" that prices do not soar to such hights then fewer "green cars" will be demanded today and suppliers will be less likely to develop them.

This is the reason that stories such as: , do not make me happy.

I agree with some folks who commented on my last posting that activist government may not really be able to make a real dent in reducing oil prices by shifting supply but the key issue is perception. Do "the people" believe that they are implicitly insured against rising oil prices? If they believe that the government is protecting them then they will invest less in "self protection" such as buying a green car or configuring their lives such that they can easily substitute away from oil when its price rises.

So this is really a posting about free market environmentalism. If the government could pre-commit to not get involved with the oil market how would this affect the demand and supply for green cars?