Misperception and Misdirection: A Look at Energy Price Controls

Much of our energy trouble in the United States is self-inflicted because of our reluctance to allow domestic prices to rise to world levels. OPEC sets oil prices and, in effect, sets all energy prices because an oil price increase is quickly translated into energy price increases across the board. In part, OPEC price increases may well reflect changed conditions. Because of increased world-wide automobile ownership and environmental regulations that fall heavily on energy production, some energy price increases would likely occur even in a competitive market. It is also possible that multinational oil companies pumped OPEC oil at a faster rate than was economical—if they perceived the risk of nationalization or expropriation of their holdings. Despite these qualifications, it seems clear that most of the OPEC price Increases indeed involve the action of a cartel.

Now, the way to break a cartel is by increased production, but domestic energy price controls set below market price do the opposite. Because higher prices are perceived as unfair, we end up by helping OPEC and hurting ourselves. If we produced no energy and if we believed that higher prices were unfair and set lower domestic prices by controls, OPEC would still demand payment at its price; the lower domestic prices could only be paid for by subsidies and, behind those subsidies, by taxes. Moreover, consumers would not get the signal to consume less. Because we produce energy, we can force U.S. producers to do so at the lower, "fair" price for a while. But eventually those low prices tend to dry up domestic supplies, and we are forced, more and more, to rely on OPEC.

Gradual decontrol of oil prices was initiated in June 1979, and, if it continues as planned, domestic oil prices as of October 1981 will be close to the world level. Thereafter, however, prices will be pegged to the general rate of inflation rather than to world (or OPEC) prices. Similarly, the expiration of natural gas price regulation is set for 1985, but further extensions would not be surprising.

The underlying rationale for price controls appears to have these elements: (a) once oil or gas is discovered, a fixed amount of output will be produced—whatever the price; (b) price incentives can bring about some new discoveries, but they are very likely to be modest because we have discovered roughly all there is to be discovered; (c) it is unfair to set prices too high; (d) the poor will suffer inordinately if controls are removed; and (e) removal of price controls now will fuel inflation. Some rebuttals to this rationale follow:

1. Old oil or gas wells likely could produce more at higher prices; for example, secondary recovery techniques could become economic at higher prices. Again, a low price could cause a well to be shut down earlier than necessary.
2. The only way to check the validity of imminent depletion is to test it in practice by allowing prices to rise.
3. There really is no such thing as a fair price. You might feel that a 10 percent higher price for what you sell and a 10 percent lower price for what you buy would be fair. But then, so might parties on the other side of those exchanges and with as much justification.
4. If the poor really do bear more of the burden of decontrol, then consider compensating them by income supplements. However, then the problem is one of poverty and not of energy.
5. The inflation argument is somewhat inaccurate and considerably misleading. It is inaccurate because measured price indexes have basic flaws. It is misleading because its focus is on price rather than on real income, and it fails to discriminate between two very different cases: (a) a general increase in all prices and in money income versus (b) an increase in the price of one commodity (or group of commodities) only, with no compensating increase in money income.

The official consumer price index—and indexes generally—have the basic flaw of assuming an unchanging market basket. But if one commodity increases markedly in price relative to all others, consumers will shift away from that item. As a result, the market basket changes. Consequently, price indexes always involve some overstatement and, in the case of marked energy price increases, could involve a fair amount of overstatement. Because energy prices to consumers, until recently, did not increase as much as commonly perceived, past measurement error was probably modest; however, future measurement error is likely to be of more consequence.

In its pure sense, inflation to the economist means an increase in all prices although real income is unchanged. In the purest sense, all prices increase in the same proportion. The causal mechanism typically is an increase in the money supply, or its equivalent—an excess of government spending over revenue. If dollars double but goods remain the same, then prices double. In effect, we have changed our measuring rod, as if we had decided to label a half-inch rather than the inch as one unit. Consequently, a foot will now "trade" for 24 units rather than 12, but real lengths are unchanged. In institutional practice, however, the numerical measurement of debts remains unchanged, so that a dollar of debt is cut in half in real terms, given a doubling of the general price level (all prices). This is pleasant for debtors and unpleasant for creditors. In U.S. history, inflation was a preferred device for redistributing income from the rich (creditors) to the poor (debtors). Unfortunately for egalitarianism, the identification of the poor or relatively poor with debtors is no longer so clear-cut. The erosion of some savings of the relatively poor (assets in monetary form such as life insurance), the uncertainty imposed on planning, and the time and effort spent in getting around or ameliorating the effects of inflation are some of its real costs. If it is very difficult to protect savings under inflation, then investment, and consequently income growth, may suffer. But this is a consequence of our institutional practice in measuring debt; in countries where indexing occurs, inflation is a nuisance but its real costs are relatively less serious.

In contrast, an increase in the price of one commodity (such as energy) could be balanced by an offsetting decline in the prices of other commodities that just manage to keep real income unchanged. More generally, however, an increase in one price is usually associated with changes in real income. If the price rise occurs in something we buy (or import), rather than in something we sell (or export), and nothing else changes, then obviously we are worse off because our real income has declined. This is the nub of our complaint, and it is undiscriminating to label the problem one of inflation. In effect, OPEC has imposed a considerable tax on us, and the OPEC cartel members are the chief beneficiaries of that tax. Removal of price controls would shift some of those benefits from OPEC to domestic producers and to the federal treasury, depending on the level of excess profits tax ultimately imposed.

I have estimated that energy spending in 1972 accounted for about 5 percent of personal income and that household spending on energy equaled roughly half of all spending on energy.

Given those numbers, I would guess that the energy price increase initially cost Americans roughly 1 to 2 percent of their real income and that, although some of that impact was ameliorated over time as people adjusted to changed circumstances, our growing import dependence on OPEC probably has balanced that trend. Hence, the tax bite by OPEC has likely absorbed a large percentage of our growth in income in recent years. As a consequence, the perception of a moderate price increase through 1978 does not preclude me from also agreeing with the general perception that the energy crunch is a pressing national problem with major consequences. The 1979 round of price increases underscored that conclusion. I would even agree that energy price increases may have contributed to inflation, but I see the process as indirect. As U.S. Rep. David Stockman (R.-Mich.) has suggested, the industrial nations may have inflated their economies in an attempt to counter the depression-inducing impact of the OPEC price rise; in any event, this counter strategy was not too successful.

Because the energy market has inelastic demand and supply, short-term shifts in supply can cause considerable price swings, perceived as gluts or shortages in quantities available as prices are on their way to a new equilibrium. In the longer run, however, it seems reasonable to expect upward pressures on energy prices from increasing world population, automobile ownership, and environmental concerns. Doubts about nuclear power, fed by the Three Mile Island scare, OPEC's successes to date, and Saudi Arabia's dominant position in OPEC, and the perception by potential competitors of the benefits of monopoly must dampen hopes that the pressures will be countered or greatly slowed by competitive forces. The availability of synthetic fuels implies an upper bound on price increases. However, although those fuels should eventually become economic, the recent interest in speeding their production seems decidedly premature. Why pay double for what might be available for a considerable period at current market prices, given an end to controls? With an end to controls, I would expect prices for consumers to increase somewhat, followed by a gradual upward trend for great many years before the price reaches the synthetic fuel level.