Reducing U.S. vulnerability to oil supply shocks: reply.

• Author: Yucel, Mine K.
• Position: Response to an article by Edward Tower in this issue. 1093

Professor Tower's alternative structure for the cost/benefit analysis of protectionist policies is a welcome extension of my recent paper published in this Journal [1]. Although I don't agree with all the particulars of his comments, overall, the extension would enhance the policy relevance of the paper. In my paper I evaluated several ways to reduce U.S. vulnerability to oil supply shocks including a tariff, a gasoline tax, the Strategic Petroleum Reserve (SPR) and a tariff and gasoline tax together with the SPR. The vulnerability measure is the present value of the welfare loss from a supply disruption. I calculated the vulnerability measure given a policy such as a gasoline tax or import tariff and compared the measure to the free trade case. The probability of a supply disruption was assumed to be 100 percent. Professor Tower's suggestion is to calculate the expected cost/benefit of a policy by maximizing welfare under different probabilities of disruption.

Professor Tower suggests that the best policy is one which minimizes the expected potential loss from a supply disruption plus the by-product loss from the policy. More specifically, he suggests that given the probability of the supply disruption, we find the best policy by maximizing expected welfare. Maximize ". . . the welfare under the supply disruption and the policy in question (e.g., the tax) minus the welfare under the supply disruption and a benchmark policy (e.g., free trade)" times the probability of a disruption minus the cost of the policy if there is no disruption. He expects that an ad-valorem oil tariff would be optimal even with no disruption, and possibly even a gasoline tax could be welfare enhancing if OPEC is a Stackelberg follower and the U.S. is a large player in the world oil market.

Adding the probability of a disruption would enrich the analysis in the paper. However, changing the objective function from the maximization of producer profit to maximization of welfare should not change the ordering of the policies. If OPEC as dominant firm remained a constraint in the maximization of welfare problem, and if the problem was set up analytically such that OPEC could retaliate to changes in U.S. oil policy, the results should remain the same. In previous work, I have used a cost/benefit approach similar to Professor Tower's suggestion (but with maximization of profits being the objective function) and the results support his intuition with respect to tariffs. In...