AN ECONOMIC ANALYSIS OF OPTIMAL OIL INDEPENDENCE

T. RANDALL CURLEE, Purdue University

Abstract

This study addresses four questions that are significant in the formulation of oil independence policy: (1) What are the sources and potential costs of the oil dependence problem? (2) How can these costs be reduced or prevented--i.e., how can greater independence be achieved--and what is the optimal level of independence? (3) Will the private sector provide this optimal independence level? (4) If government intervention is needed to increase independence, how can the optimal intervention be determined, and how can a government independence program best be implemented?^ In the 1970's, the world oil market has experienced rapid, sharp increases in price and unexpected disruptions of oil shipments. It is shown that the sharp increases in domestic oil prices that accompany such events impose both short- and long-run domestic surplus losses. A general model of dependence is developed that characterizes the optimal responses to import disruptions and world price changes under uncertainty. The margins of response considered are storage capacity, additional-production (supply) capacity, and flexible-use (demand) capacity. The expected benefits of these margins of response are weighed against their costs to determine optimal independence.^ Two market failures are addressed that may imply that the private sector's response to the oil dependence problem is less than optimal: market externalities, and the lack of perfect contingent commodity markets. It is shown that, depending on the assumptions, government intervention may or may not reduce the severity of the dependence problem caused by such market failures.^ If government intervention is used, a variety of measures are available to reduce our oil dependence. Assuming that a tariff on imports and a tax on domestic production are used to raise revenues to fund the government purchases of oil storage, additional production capacity, and flexible-use capacity, an optimal level of government intervention is described.^ Finally, this study summarizes the U.S. government's current response to the oil dependence problem and suggests future areas for research in this area. ^

Degree

Ph.D.

Subject Area

Economics, General

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