Let's Hope Our Senators Didn't Sleep Through Econ 101

I've been on the road for a couple of weeks, so I'm only now catching up. This piece ran in the Newport Daily News of 30 May. Of course, the title is wishful thinking.

By the way, I believe gasoline prices will drop from their high point at the end of May. The last couple of weeks vindicate this view. But the underlying market dynamics--increased demand for petroleum and petroleum products driven by the growth of the Chinese and Indian economies and the continued growth of our own--mean that the overall trend will be toward rising prices.

Let’s Hope Our Senators Didn’t Sleep Through Econ 101

US gasoline prices have surged recently to an average of over $3.00 a gallon. Some energy analysts are predicting that the price will reach $4.00 a gallon later this summer when demand for gasoline normally peaks.

At times like this, the natural, if misguided, impulse of politicians is to “do something.” One of those “somethings” in this case is to legislate against “price gouging.” And sure enough, the House of Representatives recently passed legislation that would make gasoline “price gouging” a federal crime. The Senate is considering similar legislation: On May 8, the Senate Commerce Committee reported to the floor a “fuel economy” bill (S. 357) that includes an amendment offered by U.S. Senator Maria Cantwell (D-WA) that would do the same.

“Anti-gouging” legislation is problematic on at least three levels. First—good intentions aside—“anti-gouging” legislation is a form of government price fixing, which will interfere with the ability of the market to efficiently allocate scarce resources. As any freshman economics student can tell you, the market sets the price of a commodity by equilibrating supply and demand. If the government sets a maximum price that is lower than the one established by market forces, the result is a shortage—the quantity of the commodity demanded at the lower price exceeds the quantity supplied at this price. If passed and implemented, this legislation will ensure that less gasoline is available while simultaneously guaranteeing that consumers will demand more of it.

The fact is that a rise in the price of a commodity is the market’s way of causing consumers to ration that commodity while attracting new supplies. This was what happened in the aftermath of Hurricane Katrina. Higher gasoline prices in the South resulting from the widespread damage to refineries attracted fuel supplies from other regions, both inside the United States and from overseas, eventually driving prices back down. Had “anti-gouging” regulations been in effect at the time, it is very likely that these supplies from outside the region would not have arrived, making a bad situation much worse.

The reason for this is the consequence of the bill’s second problem: its overly subjective language. Subjectivity is hardly a rational basis for establishing criminal liability for refiners, suppliers, or independent gas station owners. “Anti-gouging” legislation increases the uncertainty of those who supply and distribute energy, serving as a disincentive to those who would otherwise redirect resources into an area affected by an event such as Katrina because of the distinct possibility, indeed likelihood, that a supplier responding to market forces could be charged with “price gouging” and subjected to legal action.

Finally, the legislation is unnecessary. As long as gas stations provide motorists with price information, which they do—to the tenth of a cent—on large signs, “price gouging” is difficult, if not impossible.

The fact is that gasoline prices differ locally for a number of valid reasons. For instance, widely varying federal, state, and local taxes and environmental regulations contribute to substantial differences in the price of a gallon of gasoline from one locale to another. A price might be higher in one place than another because of regulations that mandate the use of expensive additives, for example the federal requirement to add ethanol to gasoline in certain places. Such regulations also tend to “fragment” the gasoline market, for example mandating the use of "reformulated gasoline" (RFG) in certain areas of the country, making it difficult if not impossible for suppliers to shift gasoline stocks efficiently from one part of the country—or even one part of a state—to another. But the Stupak and Cantwell bills open the door to criminalizing normal price variations.

So what has caused the recent spike in gasoline prices? The consensus among industry analysts is that it reflects the effects of the seasonal increase in demand for gasoline on the one hand and the fact that refinery capacity lags behind demand on the other. There are currently no refineries being built in the United States.

The capacity problem has been aggravated by accidents and unplanned shutdowns at the time of the year when refineries shift production from heating oil to gasoline. One reason for the recent rash of shutdowns is that refiners deferred scheduled maintenance in the wake of Hurricane Katrina to keep operating. Now they have to deal with the resulting maintenance backlog.

As the Senate considers “anti-gouging” legislation, let’s hope our RI senators didn’t sleep through Econ 101. Let’s also hope they will examine the historical record of government interference in the market, which demonstrates that the unintended consequences of well-meaning legislation usually make the problem worse.