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Monday, September 05, 2005

Should Oil and Gas Prices Be Capped?

Now that Katrina has passed, a significant portion of our nation's refining capacity has been taken off line at least temporarily. As a result, gas prices have increased significantly (who thought we'd be nostalgic about gas at $2.50 per gallon). For example (using the gas station on the corner I drive past each day), on Wednesday a gallon of regular was in the mid-$2 range. On Thursday morning, it jumped to $2.99, and was up to $3.49 by Thursday afternoon (it's stayed around there since).

Let the public outcry about "price gouging" begin. For a few examples, see here (San Diego) here (Wisconsin) and here (randomly picked blogosphere rant).

I'd expect that people who read finance/econ blogs are a bit more knowledgeable about prices, supply and demand than the average moonbat. But just in case, Steve Verdon at Outside The Beltway has a great piece titled "Elementary Economics - The Price As A Rationing Mechanism". He does an excellent job of explaining that 1) There's not enough gas for everyone to use unlimited amounts, 2) As prices rise, demand for gas drops, and 3) As prices rise, supplies of gas will increase.

Click here for the whole thing.

I'll add a few points:

1) Gas is a "scarce" resource". That means there's not enough gas to satisfy all demands for it. In other words, if gas were free, there wouldn't be enough to go around.

2) This means we have to have some mechanism to allocate the available gas among the people who want it. You can do it by lottery, by government fiat (i.e. you get a "ration card"), by random chance, by staying in line, or by market mechanisms (i.e. prices).

2) There are always alternative uses for any resource. For example, if there's limited amounts of gas, it can be used to drive your car 100 miles to visit your favorite restaurant, or it can be used for driving someone else for work. If supply decreases (say, following a hurricane), prices rise. If they rise high enough, you might decide that it's not worth it to drive to your favorite restaurant, and instead you might choose to drive to one closer so that you have more money to spend on other things. This leaves more gas available to the folks who place a higher value on it.

3) As article above explains, Demand and Supply aren't fixed - they're tied to price. In other words, as prices increase, the demand for gas drops (people drive less). More important (at least as far as the current gas situation goes), as prices increase, supply increases. So, higher prices give gas producers greater incentives to bring refineries back on line faster.

The end result of the effect of supply and demand is that prices give signals to suppliers (to produce more) and demanders (to drive less, unless it's really, really important) that make them change their behavior. As a result, things correct over time.

Of course, there will be many calls for government to "do something about gas prices". Those making these calls have probably forgotten the not-so-good old gas rationing days of the Carter years. A little history shows that if the government sets prices lower than the "market clearing" price, it messes up both the demand and supply sides of the equation.

From the demand side: since the price is "low", there will be excess demand. In other words, people will want more gas than is available. So, there has to be some way to allocate the available gas (government rules, "first come, first served", etc...).

From the supply side: there will be less gas supplied than there would be at a higher price. In the Carter years, there was little incentive for the producers to make a lot of gas available, since it would sell at a lower price. The supply of gas isn't fixed - just "fixed at a given price". In other words, some oil can be refined into gas at at a cost below $1 a gallon. So, this gas can be sold at a profit at $1+ per gallon, but not below that point. Some oil can't be refined into gas at a cost below $2 per gallon. So, this gas wouldn't be produced unless it could be sold for more than $2, and so on.

One last thing to think about - once the Carter price controls were rescinded (following Reagan's election), supplies increased and prices quickly fell.

Or, as Santayana said, "Those that forget the lessons of history get to enjoy them all over again."

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