Price Caps

Thursday, August 25, 2005
OK, just another reason why government is a bunch of idiots. In Hawaii, they are instituting a cap on the wholesale price of gasoline. This is a horrific idea. Living in California I am accutely aware of the pain that high gas prices can bring but having government place caps on the price of anything is just a bad idea.

Free Markets depend on supply and demand. If prices are not allowed to adjust than there is an imbalance somewhere. My incentive as a supplier is to supply gas at a price P I can make a profit at. When the price of my product reaches a certain level I have an incentive to produce Q amount. If the price goes up I have incentive to produce a little more. As a consumer my incentives are reversed. These two forces almost magically move the price to a point where all the consumers demands are met for a given price point.

Governments mess with incentives at great peril. Seriously, incentives move humans. If you put a price cap on a free market system the effects are quite obvious. The price is lower than what the producer can make a profit at. He has no incentives to produce more. However, since the price is artificially low there will be greater demand for the product. Therefore a shortage will ensure. People who want gas will not be able to get gas. Producers will not produce more gas at a loss so the supply curve can not shift outwards.

Imagine for a second if government, to stem the tide of housing cost, put a cap on the sale price of homes. Now all homes have a maximum price of $100K. Don't you think there would be a huge rush of people wanting to buy homes? Don't you think the people selling their homes would look at that and say, "No way in hell am I selling my $500K home for $100K!" Builders, not able to turn a profit on new homes, refuse to build more and instead concentrate on commercial real estate. Many people want homes but none are for sale. People are unable to relocate for work because they are not willing to sell their homes or can not find any homes to buy. The economy would grind to a halt because there would be an inefficient allocation of resources.

So tell me again, what is good about price caps?


susan said...

On the other hand,(Susan the devil's advocate says) the state already regulates other energy sources such as natural gas and electricity so maybe gasoline should be regulated in the same fashion. Just today I was hearing how the regulatory commission is hearing the power company's bid to raise rates. Why shouldn't gas companies have to do the same?

susan said...

Oh yeah, BTW, that housing price cap idea? Don't be giving the government any ideas. They have enough bad ideas of their own.

T said...

No Joke Susan. We can joke that government would never do something that stupid but I'm sure that before 1913 people thought the government would NEVER tax income. Well look what we have now.

Ryan said...

I agree that price caps are generally terrible. However, this one is not quite as stupid as it appears and I'm interested to see what happens.

First, regardless of what news headlines say, Hawaii has NOT placed a cap on retail prices. They have placed a cap on the wholesale price coming from refineries. The profit margin at the refinery level has skyrocketted recently despite the increased costs to them. This seems quite contrary to normal market forces. If steel prices go up GM's profit level goes down. Why is this effect inverted for refineries?

In fact, their profit level is so large that crude oil would have to hit $80 per barrel before the price cap reduces refinery profits to the level they were in the '80s and '90s. And even higher to make selling gasoline to Hawaii unprofitable. Certainly if the crude oil prices do go up past $80 Hawaii would be fools to keep the price cap in place. But, until then it will likely be beneficial to Hawaii, rather than harmful. Or maybe it will cause problems. It's hard to say. The answer is not obvious.

And I'm not commenting on whether this is right or legitimate. Just that it's not as stupid as it seems.

T said...

Ryan, you actually further reinforce my point. This change does nothing to the retail price of gas. In fact, it might just worsen the situation.

It is very easy to imagine a scenario where the price caps cause the refineries on the island to pump out less gas. This causes a supply shortage. Since the retail price of gas isn't capped, stations are free to charge what they want. Not only do you have less gas, its more expensive and the only people who benefit are station owners who make even more profit.

Yeah, great idea.

Anonymous said...
China controls gas prices - it doesn't seem to be working

Anonymous said...

oil price falling in the long view


Ryan said...

This change does nothing to the retail price of gas. In fact, it might just worsen the situation.

No. The retail price of gas would only increase if gas retailers collaborated in price gouging. (which, presumably, Hawaii is not worried about) Otherwise competition will keep the retail price within a reasonable range since their costs are fixed and the supply will be constant (see below).

price caps cause the refineries on the island to pump out less gas.

Not at all. Refineries will continue to output gasoline as long as it is profitable to them. That's what companies do. As I pointed out in my first comment the price cap does not make refineries unprofitable any time soon. In fact, since their profit margin is smaller it would be doubly stupid of them to simply produce less. As long as they are in the black every gallon of gas they don't sell is lost income. Unless you expect the refineries to act irrationally, you can't say they will cut back production just because they are making a smaller (but still positive) amount of money.

T said...

Suppliers supply product based on their ability to make profit on the margin. Each unit of output cost a little bit more to produce. When you reduce the price a supplier can get he will react buy supplying less. If I can sell 5 widgets at $8 I'm almost for sure willing to sell you more than 5 widgets at $10. The reverse will hold true as well. It might cost me $6/unit to make 5 widgets but it will cost me more than $6/unit to create the 6th widget (true unless you are talking about a good like software)

Now when supply is contracted what happens? There is a shortage, supply does not equal demand at that particular price point. The only way demand can be reduced is for the price to rise. Consumers, wanting gas, will bid up the price of gas. Since there is no restriction on the retail price of gas the price will rise.

Just look at the supply and demand curve. Look at the supply that will be available at a given price point. Label this Qs. Now look the price point at the demand, Qd. Qd is much larger than Qs. The only way to reduce Qs to meet Qd is to increase P until Qd is equal to Qs.

So no, I disagree with your analysis. No collusion or gouging is necessary, just simple market forces.

Your analysis assumes I will produce so long as there is ANY profit to be made. This is not true. Producers look for profit on the margain. If they can get better profits by reallocating their resources somewhere else they will.

Think of it this way. All else being equal and risk not a factor, can I make money by putting my cash in a money market or by investing in US treasury bonds. Sure I can make SOME money in the MM, but I can do better by reallocating my resources somewhere else. The same thing will happen here.