Junk Science

CNN reports the state of Hawaii has decided to cap wholesale prices for gasoline.

The refiners weighed in against it last month, calling it a bad idea.

"Chevron continues to believe that price caps are bad public policy which will not be in the best interest of Hawai'i's consumers, and that free markets perform most efficiently and effectively in balancing supply and demand," the company's filing stated.

and in stronger terms:

Tesoro, Hawai'i's other refiner, opposed the price cap outright.

"Price controls of any type or design do not work and will create harmful market distortions that may increase the risks to Hawai'i consumers and the economy and may jeopardize the viability of Hawai'i's refining industry," Tesoro wrote.

They're absolutely right, but the state "consumer advocate" pooh-poohed their complaints.

The state consumer advocate, the only other party to weigh in on the caps, suggested changes to the price cap formula currently being developed by the PUC. John Cole, executive director of the state consumer advocacy office, wrote that the caps could increase the risk of gasoline shortages and lead to the closure of a local refinery and some gasoline wholesalers among other things. However, the office generally supported implementing the caps.

"The regulation of wholesale gasoline prices is a first in this country and the risks outlined above are just that — risks," Cole wrote. "They are not certain to happen."

Read the whole artice in the Honolulu Advertiser.

How is it that the "Dismal Science" gets treated like such a mystery? Some things about economics are complex, but the law of supply and demand is pretty simple ECON101 stuff. Any time demand rises relative to supply (or supply shrinks relative to demand) the price of the goods will rise until there is a balance.

So what does a lower price do to demand? What happens when your favorite cereal goes on sale? You buy more. What happens when Big 3 automakers give employee discounts to everyone? They sell more cars. Whatever the commodity is, when you lower the price without lowering the value the demand will increase.

What does an increase in demand do to supply? That depends. If the suppliers have capacity to increase output to meet demand without additional unit cost, they will likely do so to increase profit. If the suppliers must make a large investment (build another refinery) with delayed returns (x years to build, including cutting through bureaucratic red tape; additional y years to pay off initial investment) and uncertain levels of risk (what will the total supply and demand be in (x + y) years) then they may be very reluctant to take the risk .

And we are resource-limited in this country, when it comes to refineries. So when demand rises due to an artificially low price, the suppliers are reluctant to make the investment to increase capacity. They then have a choice. Let's assume, for argument's sake, that Hawaii accounts for 1% of all gasoline consumption in the country. Now let's also assume that the demand for gasoline in this country is 1/4% more than the total available production capacity. (That is: 1/4% of the demand is unmet. We'd use more if it were available, but it isn't.) The refiners can supply Hawaii its full demand at a lower profit margin (or possibly a loss) or they can take 1/2 of what would be sold in Hawaii and deliver it to the mainland, where it can be sold at full price. The result: the mainland gets its full demand met, while Hawaii gets only half its demand met. This is a shortage, and not a little one. This is the kind which would cause governments to be overthrown in non-democratic nations.

(I haven't bothered to account for shipping costs here. Obviously, it may be cost prohibitive to send oil to Hawaii to be refined, then ship it back to the west coast for distribution. But it would be in the refiner's best interest to refrain from shipping refined gasoline to Hawaii. The capacity of Hawaii's refineries may be the limiting factor in determining the portion of the available product supplied to Hawaiians.)

Just about everyone over the age of 10 should understand profit motive, though many have sadly accepted the idea that the people with the least right to determine the profit margin are those who have an interest in the company.

It is from that group that the question is posed:

Why can't the refineries continue to meet the demand in Hawaii at a small loss, since they would continue to profit in the rest of the country?

The assumption implied by those who ask is that the lower price in Hawaii is subsidized by the company. Maybe so. What happens when California decides to fix the price as well? The market for gasoline in the state of California is obviously larger than that in Hawaii, and it would be nearly impossible for the refiners to simply absorb the loss. They must then either pull back from the California market or increase the price for everyone else.

(It gets worse still, in the case of California. Let's say the CA market for gasoline is 15% of the total national consumption. They can only pull 1/2% out to sell at a profit, leaving 14.5% to be sold in CA at a loss or not at all. It is almost inconceivable that suppliers would continue to sell such a large portion of their product at a loss, if there is a profitable market elsewhere. It's possible that they would respond by withholding almost all shipments to California, supplying less than 20% of the demand, as compared to 50% in the Hawaii example.

There's really no question that in the California example, a shortage would result, and that the cause would be the effort to directly control prices. The difference between the actual price cap in Hawaii and a hypothetical price fix in California is only a matter of degrees. In either case it is wrong. Bad science. Foolish meddling. Just plain morally wrong.

Update: Kip Esquire has a great post on this from a few days ago.

Update 8/29: McQ covers the impact of Katrina on the situation.