Price Caps

The great state of Hawaii, a state where I once lived, is on its way to creating an energy crisis that will rival the Energy Crisis of the 1970s.

Hawaii has decided to enforce a cap on the wholesale price of gas, a move they believe will help curb the rising price of fuel.

Now, that is all good and swell, for who likes these prices? I sure don’t. I mean, I have to drive “down the hill” (for those of you outside of Colorado, that means out of the Rocky Mountains and into the plains, or I my case, the Denver metro area) to get to my community college where I attend. That is a pain in the wallet.

Being knowledgeable about economics (I plan to be a business major when I enter college), I see Hawaii’s move as one that will usher in a new energy crisis for that state (and if other states follow, the entire country).

Why is a price cap on gas the wrong way to go about fixing the problem of high gas prices? Because price caps, by their very nature, act contrary to economic theory.

I am going to go through this topic very briefly (I once wrote a 10 page research paper on this very subject), so please contact me if you desire a more complete explanation (I only answer blog emails on Tuesday and Thursday by the way).

Price caps are a form of law that the government places on private companies. These laws dictate to companies (in this case, gas suppliers) how much they can sell their product for.

Let’s study an easy example. Let’s say gas prices in Colorado are $3.00 per gallon (actually, right now they are somewhere in the mid-$2.50 range). Let’s say the Democratic controlled Colorado State House and State Senate pass a law saying gas suppliers cannot sell their product for over $3.00 a gallon.

What will the reaction be of the supplier? The supplier of gasoline will see that he cannot, by law, sell gas for over $3.00 a gallon. Therefore, when the supplier buys gas, he will only buy as much as can be sold for under $3.00.

Since the gas station owner is only buying the amount of gas that can be sold for under $3.00, some gas that normally would have been bought by the gas station is now not being bought. Well, you might say, the free market will take care of that and buy the remaining supply. Wrong.

It is not a free market anymore, you see. As gas becomes more scarce, the price will go up over the $3.00 point. At that point, the gas cannot be legally bought because the pump is not allowed to sell it for that much.

What will the oil refinery do with the unsold gas that has not been bought? Initially, that gas will go to waste (or be given away to clear inventory that cannot be sold). But the refinery is not stupid. The refinery knows that it is producing TOO MUCH gas for the market (thanks to our good friends in the government) and will decide to not produce any more gas than can be sold.

What happened in the end then? The gas station has decided to not buy as much gas as it used to. Now, we have a gas shortage. The refinery has also decided to stop producing as much gas. Right there, we have an even larger gas shortage.

So, as you can see, the price cap didn’t do its job very well. Instead of just high gas prices, we have high gas prices AND a gas shortage. That is only half of the story.

What happened to the consumers? When the price cap hit, there was a shortage of gas at the station. People who need gas will (wisely) decide to go to the station early in the morning to get the gas they need so that the gas station will not be sold out when they really need gas. The only problem is that 100 other smart people thought about the same thing. Therefore, when they arrive at the station, there is a line, a LONG line (in this case, 100 people). The line will only get longer.

When people see lines, they will start to panic about the shortage. Now everyone is going to start getting in line for the gas that is going to run out. So now we have high gas prices, a shortage, and LONG lines at the gas stations. Seems to me that the government, in its infinite wisdom, didn’t solve a thing, but instead (as they nearly always do when they mess with economics) made the situation worse.

How will we fix this problem then? The free market always fixes its problems, right? Most of the time, it does, but this is not a free market, you will recall. It a government regulated market now. In theory, the situation will go on indefinitely unless someone eradicates the price caps.

But don’t take my word for it. Just look at what happened when Nixon put price caps on gas. It was one of the key contributors to the Energy Crisis of the 1970s. The problem is, if we are not careful, our situation could turn into a much worse energy crisis. I would suggest, then, that we not place price caps on gas. We may be headed to an energy crisis without price caps anyways, so let’s not make our situation even worse. Oh wait, Hawaii is about to fix that, and the whole country may soon follow.