Econ 101: What Happens When We Subsidize

     President Bush, in his State of the Union speech, said America was addicted to oil and the federal government would use billions of tax dollars to pursue alternative energy sources. Rather than accepting this at face value, we might ask if the presidents appeal to the green coalition makes sense.

     First, we are addicted to oil only in the sense that we use oil to produce goods and services, from plastic action figures to transportation. The United States uses a large percentage of the worlds oil because we have an economy that produces $13 trillion per year in gross domestic product. We could reduce substantially our reliance on foreign oil simply by producing less. But there are very few of us who think a 20-percent reduction in our standard of living would be a good thing.

     Second, it is not likely that the bureaucrats, legislators or cabinet members will be able to make use of these billions of dollars of taxpayers money efficiently by investing in alternative energy sources. (I say this even though a friend of mine, who is very bright, was Secretary of Energy for several years.) Ludwig von Mises in 1920 pointed out that central planners will always be faced with an insurmountable information problem in determining how to allocate resources.

     The central planner cant possibly know how much consumers value different products and the most efficient way to produce the millions of products. How can the Secretary of Energy have any idea what types of alternative energy sources, and what mix of them, is best for maximizing the production of goods and services in local areas?

     When I was in graduate school in the mid-1970s, many articles and books claimed the world would run out of oil by the year 2000. Of course, 2000 came along and gasoline prices adjusted for inflation were lower than they were when those doomsday books were written. Common sense will tell you that we will not run out of oil any more than we ran out of whale oil.

     As the price of oil rises, the quantity demanded will fall, and the quantity supplied will rise. The increase in prices will generate short-run profits, but these profits will attract new entrants into the field. More companies will go into the oil-finding business, and the existing companies will find it in their interest to increase the amount of resources they use in exploring for oil. Other companies will have the incentive to do things like figure out how to unlock the oil from sand in Canada or develop some kind of synthetic oil. This is why we have not run out of oil as projected by those who ignored the effect of the price system and the role of profits in a market economy. It is also the reason why we will not run out of oil in the future.

     When the price of oil gets sufficiently high, it will make sense for entrepreneurs to use their time and talent and risk their capital in discovering alternatives to oil. It is more than likely that some alternative energy source will become commercially viable when the price of oil gets sufficiently high. The greater the increase in the price of oil the more quickly we will develop commercially viable alternative energy. Either the oil companies will find new technologies to make more efficient use of existing oil or see the advantage of using alternative sources in the face of rising costs of finding additional oil. New companies will develop alternative energy sources in an attempt to garner the profits that will come when people switch to this new energy.

     The potential for profits to be made by finding an alternative to oil are what attract the risk capital of those who would develop energy that is more stable in supply and cheaper in price than oil. (Taxing these profits would be the worst thing to do if we would really like to reduce our dependence upon oil, as it would be a signal that if you are an entrepreneur and are successful from taking on enormous risk, then the government will tax away your profits.)

     If the federal government subsidizes the development or use of alternative energy, then it will create the wrong incentives, and the more the federal government spends in this arena, the worse things will be. The political entrepreneurs will take the lead. Those who are connected enough to the government to get the subsidies will make the profit. There is no reason these firms will be producing an alternative that consumers will find beneficial. There is every reason to believe these firms will be producing a technology that those with political power most favor. Rather than spending resources trying to please consumers, firms will spend resources trying to please those who control the billions of dollars of taxpayer money.

     If the federal government really must subsidize alternative energy, it should simply offer a prize of $1 billion to whoever can produce an alternative energy source that can meet certain performance conditions. Picking and choosing who is to get the money based on the government bureaucrats best guess cannot be efficient. Let the entrepreneurs take the risk and enjoy the rewards for satisfying innovative performance criteria.

     Even so, such a contest would not be the best use of our resources. Simply letting the market system, which has created the greatest standard of living for the poor ever seen, work would ensure us that we will be using the mix of energy resources that will most benefit society.

     This is not rocket science by any means. Adam Smith explained well more than 200 years ago that in a market system individuals pursuing their own self-interest will lead to the greatest benefit for all in society. Mises and Nobel Laureate F.A. Hayek explained why governmental control over resources cannot produce wealth for the masses because government planners can't solve the problem of decentralized knowledge. Another Nobel Prize winner, James Buchanan, explained why the incentives involved in a governmental system would result in the resources going through that system being directed to those with the most political connections. Why would we ignore these great economists and think that the same government that brought us FEMA and Halliburton contracts would successfully use our money to find the ultimate alternative energy system?