Price Controls Do Not Control Prices

As the fighting raged in the Persian Gulf, the conversation in my college economics class invariably turned to the conflict—and its economic effects. In the past several months, students have seen gasoline prices rise and fall rather violently and are puzzled by the whole affair. “How many of you believe,” I ask, “that had the government kept price controls on gasoline instead of lifting them in 1981, gas would be cheaper at the pump than it is now?” Forty hands rise as one, matching the number of students in the room.

I’m not surprised by their response, for even though this is an upper-division class, rarely do college students learn the origin of prices in principles of economics: And even had they learned the dynamics of price theory, most likely they would also have remembered the professor telling them that price controls do produce lower prices—even if those controls cause other economic dislocations. Price controls, their textbooks said, deliver at least some of the goods.

“If we adjust prices to inflation,” I ask, “what, then, would be the 1980 price of gasoline compared to what we pay now?” No hands are raised. “Let’s try $2 a gallon,” I say, answering my own question. “And remember that in 1980, the U.S. Department of Energy set gasoline prices ostensibly to protect consumers.” The student in the back of the room who had his head on the desk raises up to listen better; suddenly, the discussion has become more interesting.

In the days since Iraq’s August 2 invasion of Kuwait, we have seen oil and gasoline prices rise and fall with intensity. A few days before the invasion, the price for a barrel of oil stood at about $18. By October the price was $40, and “experts” told the U.S. media that, at best, $30 would be the new floor price. By January 15, the U.N. deadline for Iraq to leave Kuwait, prices were slightly below $30. A day later, they had plummeted $10 a barrel.

These numbers are even more significant when one takes inflation into account. In the early 1980s, when the Department of Energy was setting domestic oil prices, the world price for a barrel of petroleum stood at about $40. After accounting for a decade of inflation, the $40 barrel would be about $60 today. The 1981 peak price of $1.41 for unleaded regular gasoline would equal $2.10 today.

But even though the prices of oil and gasoline have fallen substantially since their autumn highs (on December 1, I paid $1.39 for a gallon of regular unleaded at a nearby gas station; in mid-April, I paid $1.02), the public is still unhappy, and Congressmen have responded by introducing dozens of bills to reimpose price controls.

Do Controls Really Work?

The dynamics of price controls are misunderstood, even by economists. Most economics textbooks accurately portray what happens when government imposes price controls, at least in the short run. Because price performs the vital role of allocation of resources, a price held below what the market will bear causes dislocations in the form of shortages. In the case of gasoline price controls in the 1970s, shortages meant long lines and empty gas pumps.

The gas lines were only short-term effects of price controls, however. Within a few months after the initial crisis, allocation procedures plus the imposition of gas rationing by some states returned what seemed to be a normal market. This was what happened in 1973 and 1979.

An Emerging Pattern

When one examines the two supply shocks in the 1970s, a clear pattern emerges, a pattern tied directly to government price-control and allocation policies. First came the panic, as motorists realized prices were going to rise and that future supplies might be short. Drivers waited in long lines as they sought to purchase gasoline before stocks were depleted.

Second, prices rose as predicted, bringing an angry chorus from the public and legislators. Both times, the federal government strengthened its powers of price and allocation controls. And, both times, prices did not fall back to pre-crisis levels. On the contrary, prices remained at the current levels for a short time, then began to creep upward as inflation increased.

Contrast the experience of the 1970s to that of August 1990, when the world suffered its greatest oil shock since World War II. Within hours of Iraq’s invasion of Kuwait, prices for oil quickly rose in the world’s trading pits, increases that were almost immediately passed on to consumers—bringing the usual chorus of condemnation from politicians and “consumer groups.”

Throughout the early days of the crisis, media commentators predicted that gas lines would be next, and that shortages of heating oil and other fuels would plague our nation as cooler weather approached. Even The Wall Street Journal told its readers that “experts” were warning consumers to ready themselves for long lines. The “experts” were wrong. While gasoline prices rose quickly, Americans found that gasoline was readily available. The gas lines never materialized in 1990 and will never occur so long as gasoline is rationed by the price system.

A further important difference between the supply shocks of the 1970s and the supply shock of 1990 is what happened to oil prices after the initial crises abated. In 1973 and 1979, prices climbed to new levels and remained there; but prices during our latest crisis fell back close to where they had been before the invasion.

Why gas lines don’t form when price rations gasoline is easily explained. When outside forces (usually governmental) hold prices below market levels, false signals are sent to both consumers and producers. Consumers are encouraged to buy more than what is available on the market, while producers are discouraged from providing that commodity because they cannot receive revenues that justify production and distribution costs. In short, the system encourages consumers to demand more than what producers will make, thus creating bottlenecks in the market. This is what our nation experienced in the 1970s.

Last year, however, prices were allowed to reflect not only the sudden decline in supplies, but also the uncertainty that gripped the oil markets. Given the information available at the time, prices did not send wrong signals about supplies—as had been the case a decade earlier. And because prices transmitted accurate information to consumers, they were better prepared to make rational decisions about fuel use.

Economists have done an effective job of explaining why price controls cause economic damage, whether the damage be gas lines in California or housing shortages in rent-controlled New York City. However, they haven’t effectively shown why prices can rise in a controlled environment, yet fall in a free market. As one contrasts the oil shocks of the 1970s to that of 1990, two questions appear: “Why did prices continue to rise when regulators, supposedly working with consumers in mind, were setting them?” and “Why have prices fallen when they were left to profit-minded producers in the marketplace?”

To answer these questions, one must rerum to the original lessons learned in principles of economics. Yes, shortages occur when controls hold prices below market levels, and those shortages force consumers to incur new costs in order to obtain the commodity in short supply. As Armen Alchian and William R. Allen have pointed out, “. . . if price is restrained below the market-clearing equilibrium, other forms of competition will become more significant. Political power or other costly means of competition for the goods will decide who gets more and who gets less.” (Exchange and Production, Wadsworth Publishing, third edition, p. 62, italics in original)

When the oil shocks occurred in the 1970s, government restrained price increases. While authorities believed they were creating bargains for consumers, they were actually forcing consumers to absorb other costs to substitute for their “savings” on oil. The most obvious cost was time. What had originally been a five-minute stop at the gas station turned into a wait ranging from several minutes to several hours when motorists panicked at news of shortages. Mandatory conservation measures passed by several states, while helping quell consumers’ fears, brought about even more costly delays.

Eventually, oil prices slowly rose as Federal regulators permitted companies to charge at market-clearing levels again. New pump prices replaced motorists’ time costs, trading one set of inconveniences for another. However, because motorists understood that pump prices were legally mandated, they believed prices were at their lowest possible levels. This did not mean that they were satisfied with oil prices; on the contrary, most Americans believed oil companies were gouging them. But because the government set prices, consumers had no expectations of oil prices ever falling significantly. Consumers believed the government was “protecting” them (though not protecting them enough, according to critics).

Cost-Plus on the Supply Side

When the supply shocks from the 1979 Iranian Revolution hit the oil market, gasoline prices couldn’t be kept at pre-revolution levels, since oil producers would have had to sell at a loss. As is the case with almost all price controls, the Energy Department based prices on a cost-plus formula. Using industry-supplied figures, it examined the cost structure of the oil industry, then allowed a price that covered costs and afforded a “reason able” profit.

In an economy with even moderate inflation, operating costs increase on a regular basis. With U.S. inflation in double digits by the early 1980s, there was every reason to anticipate higher and higher costs in the energy industry. Federal energy regulators, using their cost-plus formula, would have passed those anticipated higher costs on to consumers. Thus, ceiling prices on oil, perversely enough, also would have served as “floor” prices. Had President Reagan continued price controls, gasoline prices most likely •would have continued to rise, and Americans would have paid hundreds of billions of dollars more for gasoline and heating oil than they did during the past decade.

Deregulation of oil prices ended the official stamp of approval on price increases. Oil companies, like airlines, had to compete in the open marketplace. Without the protection of price-setting regulators, they had to lower prices when market conditions so dictated. Oil company profits fell back to normal (and even below-normal) percentages.

Prices fell for three reasons. First, as already pointed out, the demise of price controls meant the end of “floor” prices on oil. Second, the Western industrial world, including the United States, became significantly more energy efficient. Third, oil-producing countries had to become competitive in selling petroleum.

This last factor was made possible, however, only with the return of a competitive U.S. oil market, the largest market in the world. Once the Energy Department relinquished price and allocation controls, the U.S. market had to operate according to the same laws of supply and demand that govern other commodity markets.

The dynamics of the market are obviously not limited to oil. Long-term price controls have forced up prices in other markets as well. New York City’s rent controls have created some bargains for people who have held the same apartments for many years, but have imposed higher costs upon people seeking new places to live.

A free market for oil could not protect Americans from high prices in the weeks immediately following the Iraqi invasion of Kuwait. But no energy program could have accomplished that.

What we have found, however, is that the free market enabled us to quickly adjust to the new market realities—and it rewarded us afterwards.