What should the government if we're running out of oil?

In my seminar today we had a discussion about the appropriate governmental response to the coming oil crisis (we read a paper that estimates that world production of oil will peak in 2010). Students thought the government should promote conservation, invest in research and development, and subsidize use of alternatives. I expressed shock and dismay that so many students who identify themselves as conservatives would make this proposal; surely the conservative approach is to tax oil (to the extent that there are public goods or externalities that put a wedge between the market price and marginal social cost), rather than have the government seek to manage such a large and important sector of the economy.

After class a student sent an email saying that because it would take so much time to make the transition from oil to alternatives, the current market price does not reflect oil's true scarcity. Furthermore, the public simply cannot make the transition to alternative forms of energy regardless of the price, so a more direct government role is called for. I wrote the following response to her first point, and I'm still thinking about her second point.

I’ll bet someone has written down a model in which oil (or some finite resource) is running out, there is a projection of demand and supply, and there are costs to finding alternative sources of energy that make the transition slow. I’ll bet that in that model as long as everyone has rational expectations, the price that pops out of the market exactly compensates for the transition costs and so brings forth exactly the right degree of conservation and investment in alternatives that will allow the transition to go smoothly. I’ll bet the authors of that article (if it exists) argue that unless the government has better information about future supply and demand for oil than participants in the market, it cannot improve on the market outcome and so should leave well enough alone.

So I think for an economist to argue convincingly to other economists that government intervention is necessary, he/she needs to point to common forms of market failure, i.e. externalities and public goods. I think those arguments are good ones that most economists would accept, especially regarding global warming and the cost of defending our oil interests in unstable parts of the world.

So now, if the government taxed oil to raise the price to say $100/bbl or $4/gallon of gas, could “the market” come up with alternatives in a timely fashion? That’s an open question. Maybe Toyota could but Ford couldn’t, so the US would lose out in the race for better technology. Or maybe no one is smart enough. But are our elected representatives smarter than those in “the market” who would be trying to cope with higher prices? The conservative answer is, no, so the government should not get directly involved in the search for alternative forms of energy.

So I’ll turn the question back to you: why do you think the government knows better than the private sector which are the most promising alternatives to oil or the most effective conservation techniques?

Comments? What is the liberal approach to this?