Unforeseen Contingencies

Since Americans currently pay very low prices, compared to the rest of the world, my initial reaction is simply to say “quit whining” and leave it at that. But this “problem” is suitable for some simple economic analysis.

1. Are U.S. prices the result of monopoly power? Almost certainly not. Provision of gasoline, at both the wholesale and retail levels, appears to be fairly competitive. For one thing, profit margins are not large at all – apparently slightly over 8%. (They also pay 7% in taxes on each dollar of revenue.) High total profits are largely the result of increased sales volume.

I have some suspicion of accounting figures, and so wouldn’t rest the case here. More importantly, monopolized industries restrict output, they don’t expand it to record levels. Similarly, America’s experience with price controls on gasoline consistently resulted in shortages, not expanded output.

Our experience in the 1973 gas crisis is illustrative. The Unites States had a price ceiling on gasoline when the Arab oil embargo struck. If American prices were the result of monopoly power, this control would have led to an increase in American output. Why? Because the price control had been set at the pre-embargo price, and so did not become effective until the embargo took place. An effective price ceiling will generate expanded output in a monopolized industry (since it eliminates the monopoly power) but shortages in a competitive market.

The evidence suggests that America's gasoline market is competitive, not monopolized.


2. Is there another source of monopoly power? One of my econ students suggested a very interesting counterargument to the above. (Good work, Dwayne – extra points for you!) It’s quite clear that the primary supply constraint is refining capacity, and there’s been relatively little new refining capacity in the U.S. over the last twenty years. Might there be strategic underinvestment in capacity by oil companies in order to restrain supply, thus generating monopoly prices without the obvious exercise of market power?

This argument makes theoretical sense, although it requires thinking in terms of optimal extraction paths over time, rather than a simple one period demand and supply model. But the result is essentially the same: reduce the quantity supplied and earn higher prices per unit sold. The theory makes sense, but are we observing strategic underinvestment?

I asked a petroleum engineer about this – he pointed out that within the industry, the common belief is that there will never be any new refineries built in America, ever again. Why? In three letters: E.P.A. According to my engineer, the last attempt in the U.S. to build a new refinery was in Oklahoma. The E.I.S. and permitting processes have taken 12 years to date, and are not progressing. The project has essentially been shut down.

(The engineer also gave me an earful, wanting to know why Congress is clamoring to punish oil companies for earning profits. In the 1980’s, low oil prices resulted in industry losses; he told me he had to lay off many workers, a painful experience for them and for him, and that he nearly became unemployed himself. Charles Schumer, take note.)

On the other hand, there is one way around this refining obstacle, and that is to expand and modernize existing refineries. This is a more costly and less technically efficient route, but it is all that is possible today. And in fact, this is exactly what has occurred, and continues to occur, in the U.S. Thus the evidence does not support the strategic underinvestment explanation at all.

Add to this the fact that refining capacity appears to be the major constraint worldwide, for a variety of reasons (see “Two Cheers for High Oil Prices” in the Mar/Apr 2006 Foreign Affairs). Worldwide, collusion among oil companies is even more unlikely. Paranoid conspiracy theorists imagine otherwise, but a good piece of evidence is that an important reason for the Bush administration’s invasion of Iraq was to eliminate French and Russian oil concessions. This is strong evidence against any worldwide oil conspiracy. Hence, if American firms attempted to drive prices unusually high by world standards, we’d expect foreign firms to enter the U.S. market to undercut them. Of course, American prices aren’t unusually high. They are low. (This is in part, perhaps largely, because of low U.S. fuel taxes.)

3. Are the “high” prices really a problem? No. The higher prices are important information signals. They signal strong demand, they signal scarcity of supply, they signal costs of production. This is crucial if the economy is to function without wild dislocations (shortages, surpluses, and similar wastes of valuable resources).

Higher prices give gasoline consumers increased incentive to be careful how they use gasoline, to conserve it. Drop the price, and gas will be burned more freely. Today’s higher prices are not resulting in a fall in quantity of gasoline burned, but at least have a dampening effect on consumption. It’s hard to believe that this is an enormous burden on American consumers, since we are buying increasing quantities. (And don’t forget that Americans, plus 2.5 billion Chinese and Indians, are by far the main sources of demand growth. We’re all drinking more oil even at the higher prices – this is demand driven growth.)

Higher gasoline prices increase the incentive to provide additional gasoline – and in particular, to expand refining capacity, which is the most important supply constraint. This is the one of the main conclusions of the Foreign Affairs article referenced above. Worldwide – and the petroleum market is a worldwide market – expansion of quantities supplied requires higher prices…movement along the long run supply curve.

Finally, higher prices also are vital for stimulating the development of alternative energy sources. If prices for petroleum (and for fossil fuels in general) remain low, there will be little incentive for development of alternatives. A dollar spent on R&D for alternatives will have far less chance of earning a return, and financing of development will languish.

So, the bottom line…what should government do about America’s high gas prices? LEAVE THEM THE HELL ALONE!