Government Intervention in Energy: Savior or Villain?

Every day in the media we hear words to the effect that at the present rate of consumption and given the existing reserves, America will run out of oil and natural gas in (choose one) 5 years, 10 years, 20 years, or 30 years. This statement is often made as if it were some new discovery, something we didn’t know before. But it’s not a new discovery—we’ve always known it. In fact, at the rate of consumption of oil in 1933, not exactly a boom year, reserves should have lasted only until 1946. We should have had no oil after 1946. Something went wrong, or more correctly, something went right and we didn’t run out in 1946. In fact, all people are saying when they say we’ll run out in x years, is that you cannot continue using a finite resource at the same rate indefinitely. But any school boy could have told us that; that’s just a particular application of the general mathematical principle that a finite number divided by a finite number is a finite number.

What does any of this tell us about the energy situation? Nothing except that energy is finite. But we already knew that. Energy is an economic resource, and all economic resources are finite. If they were infinite, there would be no economic problem. In fact, the study of economics would disappear and I wouldn’t be writing this article, since the whole purpose of economics is to study the allocation of scarce, finite resources among competing ends. And we can use the same economic tools, the same economic analysis, to look at the energy issue that we use to look at the meat issue or the automobile issue.

There are some general principles about how prices are determined in a free market. The first principle is that the supply of a good is a function of the price. The higher the price, the more of a good will be supplied. If you allow the price of oil to rise, it will pay to exploit oil from existing wells where it didn’t pay before(for example by piping salt water down and pushing the oil out) and it will also pay to explore for oil where it didn’t pay to explore before. Similarly with natural gas: if you let the price of natural gas rise, it will pay to explore for natural gas. “Reserves” of natural gas and oil are in fact economic concepts, defined with respect to a particular price. When the American Petroleum Institute or the federal government say there are x reserves of natural gas what they mean is that there is x amount of natural gas known about today that is worth getting today at the existing price of natural gas. However, if the price went up, there would suddenly be new reserves, because there would then be oil and natural gas worth exploiting at the higher price that wasn’t worth getting to at the lower price. That explains why we didn’t run out in 1946.

In fact, the Energy Research and Development Administration (ERDA) in a 1977 report entitled the Market Oriented Program Planning Study (MOPPS), estimated that an increase in price from $1.75 per thousand cubic feet (mcf.) to $3.25 per mcf. would double U.S. reserves of natural gas. This was their conservative estimate after two earlier estimates were rejected by the Carter Administration as being too high. Incidentally, the MOPPS study has since been suppressed and nearly all copies have been recalled from government deposit libraries across the country.

A second principle is that the quantity demanded of any good or service depends on the price. The higher the price the less of a good will be demanded. The lower the price the more of a good will be demanded. Take a case where the price of a good rises. When the price goes up, people use less and substitute other goods. For instance, when the price of oil rose, people insulated their houses more. And when the price of gasoline rose, some people drove less or bought smaller cars when they traded in on a new car. In Europe, where the price of gasoline is more than double the U.S. price due to higher gasoline taxes, most people drive smaller cars than in the U.S. These are the two principles underlying supply and demand: when the price increases, more is supplied and less is demanded.

In a free market, what equilibrates supply and demand? What brings them into equality? Price. How is the price set? Does the government set the price? No. What sets it is the fact that everyone in the market is out pursuing his own interest, and that, over time, will automatically bring demand in line with supply. Let’s say you start with a price at which the quantity demanded exceeds the quantity supplied. That means that people demand more than is supplied: there will be shortages and line-ups. Suppliers will see that they can raise the price and still sell all they have to supply. As they raise the price people demand less, and suppliers will have an incentive to supply more. The price rises to the point where the quantity demanded equals the quantity supplied. Similarly, if you start with the price at which the quantity supplied exceeds quantity demanded, then the suppliers will bid against each other to keep the price down to where demand equals supply. Therefore, shortages and surpluses are only temporary phenomena in a free market.

One of the main virtues of the free market, in fact, is its flexibility. The price of a good is free to move in response to shifts in supplies and demands. It will reach a point where surpluses and shortages are eliminated. At this point, buyers can buy all they want and sellers can sell all they want.

Consider what happens when the supply decreases. Take a particular example: the Arab oil embargo of 1967. This embargo did not get the headlines that the 1973 embargo received. One of the reasons was that the price of oil was free to rise. During the Arab-Israeli war, the Arabs embargoed Europe. The price of oil increased in Europe. Some oil destined for the U.S. was shifted to Europe in response to the higher price and the price in the U.S. rose. The result? The market cleared with a lower supply. No shortages, no lines. Consider the case of the demand shift. Imagine that people move from Rochester to Los Angeles, and drive more in Los Angeles, demanding more gasoline than they demanded living in Rochester. The price of gasoline will be bid up in Los Angeles in the short run and suppliers will respond by shipping more to Los Angeles and less to other areas of the country, until the prices are equalized (ignoring transport costs).

Price controls and the energy crisis

As Murray Rothbard says in “The Plumb Line” elsewhere in this issue, the gasoline shortage of 1973 and 1974 was caused by Nixon’s price controls.

The current gasoline shortage is caused by Department of Energy (DOE) price controls, and if the controls were eliminated the shortage would disappear tomorrow. There would be a wide disparity among prices in different parts of the country because the federal government does not allow gasoline to move freely from low price to high price regions. Instead it allocates particular quantities of gasoline to various regions. If the power to set allocations were removed from the government, the regional price disparity would also diminish in short order. Entrepreneurs would buy gasoline in low price regions and ship it to high price regions, driving the price up in the low price regions and down in the high price regions.

The current shortage of natural gas was caused by the Federal Power Commission’s controls on the field prices of natural gas, which were imposed in 1954. The shortage did not occur immediately because producers faced with a choice between producing in the early years at a controlled price or in later years at the same controlled price, rationally chose to speed up production in the early years and collect interest on their profits, rather than wait and forego the interest. However, as a result of the controls, less exploration for new natural gas was undertaken. The shortage of natural gas started in 1967, and has continued ever since, getting worse year by year, although only in recent years has it received much publicity. In 33 states there are extreme restrictions on hook-ups to natural gas and how much natural gas you can get. In most of those states if you build a new house you cannot hook it up to natural gas. Even if you are willing to pay a lot more for natural gas than the regulated price, even if you are willing to pay more than someone else who has natural gas, but just got there first, you cannot get a new home hooked up. Last year the government allowed the controlled price on natural gas to rise but did not eliminate the controls. Instead it extended the controls to the intrastate market, which had not previously been regulated by the federal government. As a result, the natural gas shortage is still with us. In many states, it is still impossible for new users to obtain natural gas.

There are many undesirable consequences of price controls. One is the line-ups. People often have to sit for hours in lines waiting to get gasoline and sometimes do not get it even at that. People get very frustrated in those line-ups and there is sometimes violence. In the 1974 line-ups some people were killed. So one of the consequences of controls is to make us a somewhat less civilized society.

Another longer term consequence of controls is that once the controls have caused the shortage, the government usually does not stop there. It decides who is at the front of the line for getting those goods that are in short supply. How does it decide that? As in the case of petroleum allocations, it often decides on the basis of who got the goods historically. Owners of old homes already hooked up to natural gas are favored over owners of new homes. Oil refiners are guaranteed a supply of price-controlled crude from the suppliers who supplied them before the controls. When retail gasoline was allocated by the government in 1974, it was allocated to the places where people had been driving in 1972. That was not where people drove in 1974, with the result that there were no lines on interstates while frustrated drivers wasted hours in line in major cities.

Sometimes, however, exceptions are made in response to political pressure. The truckers’ violence campaign in early 1974, for example, in which one man was murdered, convinced the federal government to allocate more refinery output for trucks.

The losers in this game can sometimes lose big. In the winter of 1977, over one million people were put out of work temporarily due to the natural gas shortage. Most of these people were blue-collar workers.

The government reduces the incentive to conserve energy by keeping the price low, causing those who get energy to use it in ways they themselves would consider wasteful at a higher price. Then it turns around and tells us that we’re energy pigs. As they say in Brooklyn, “what chutzpah!” But the government goes further. It imposes controls on our uses of these resources. For instance, in the winter of 1977 Governor Carey of New York decreed that firms could not use more than 75 percent of the amount of natural gas they had been using in a selected base period. The Federal government requires that cars get a certain minimum number of miles per gallon each year. The government uses building codes to require that buildings be built to use energy “frugally.” President Carter is proposing standards for appliances so that appliances will cost more to start with and will use less energy. Carter proposes also that utilities be forced to convert to coal from oil and natural gas, and that drivers be thrown in jail for driving on certain days. Finally, Ralph Nader wants an “energy conservation corps” to have power to force its way into any private home and do an “energy waste audit.”

Now, many of the adjustments the government is trying to achieve with these controls are exactly the kinds of adjustments we would have made anyway if the prices were higher. We would be inclined to shift to cars that use fewer miles per gallon. In fact we were doing that. We would be inclined to insulate our houses more. We’re doing that. Even people I know who distrust Carter had their thermostats turned down to 65 degrees. They weren’t talked into it by him; they were talked into it by the monthly fuel bill.

But there are three major differences between what we would have done on our own and what the government is trying to force on us with these controls. One is that we would have done it voluntarily and that has value in itself. We wouldn’t have had a jail sentence to face or a fine to adjust. The second, a consequence of the first, is that we would have been able to make our own adjustment in light of our own circumstances, rather than in lock-step fashion. It’s absurd to think that because the price goes up a certain amount everyone is going to want to cut his consumption by the same amount and yet that’s exactly the kind of crude mentality behind these proposals.

The third difference is that if the free market were allowed to handle the adjustment, the government would not be able to hold arbitrary power over our heads and inhibit our freedom of speech. Imagine what would happen when a government bureaucrat controlled the allocation of natural gas and a businessman whose firm used natural gas spoke out against this government control. You don’t have to be Colombo to figure the odds on this businessman’s getting all the natural gas he wants.

Now I should say something about the latest Carter proposals on oil prices. The price of “old” oil (that is, domestic oil discovered before a certain date) is controlled at $6 per barrel. The price of “new” oil (that is, domestic oil discovered after a certain date) is controlled at $13 per barrel. The world price of oil is $16 per barrel. Carter’s decontrol plan would allow the prices of oil and new oil to rise in steps to the world price by 1981. This would give producers, especially producers of old oil, an incentive to withhold their oil from the market in anticipation of the higher price. Carter’s scheme could worsen the current shortage. Instant decontrol would be preferable.

Further, Carter proposes to tax the price increase at a hefty rate. This so-called windfall profits tax is actually an excise tax on oil. The larger it is, the less will be the incentive for domestic oil producers to produce.

Energy and the free market

Without government control, how would the free market handle conservation? The claim is often made that under a free market system people don’t have the correct incentive to conserve. That claim is incorrect. We do have the correct incentive and we have it not because oil company managers are nice guys concerned about future generations, not because they’re altruistic, not because they’re benevolent, but because they’re greedy. If they anticipate a shortfall in the future, they’ll realize that the price will be higher because of that shortfall. Therefore, they’ll tend to withhold production today, and carry it over into the future. If, for example, the price of oil next year is expected to be $20 per barrel and the price this year is $16, producers will contract production now and expand production later. That will smooth out the price over time. So we get conservation because it’s profitable to conserve.

Is it necessarily the case that the managers of oil companies will make the correct decisions? Of course not. Not necessarily. They can make the wrong decisions. But at least if they make a wrong decision, they bear most of the cost of that decision, because to the extent they make the right decision they make money, and to the extent they make the wrong decision they lose money. For instance, if they anticipate a shortfall in the future and therefore hoard now in order to produce it later and in fact there isn’t a shortfall in the future, then the price they’ll get in the future will be lower than they expected. They could have sold it now for a higher price in present value terms, and they missed that opportunity. So at least the incentives are in the right direction. They have an incentive to have the right information. There’s no similar incentive in the case where the government controls that decision. In fact, if we go by recent performance of the government, the incentives seem to be in the opposite direction. Lately the government has been putting heat on firms with federal oil and natural gas leases to step up production. They want less conservation. They want more produced now, and less in the future.

Another issue is that of foreign dependence. If we don’t have some kind of government regulation won’t we be dependent on foreigners? Of course we will be dependent on foreigners. But so what? “Foreign dependence” is another term for foreign trade. Obviously, at the existing price it might be better to buy domestically than to buy from foreigners, but that’s not the relevant choice. If we want to have all domestic oil production, we’ll have to pay a higher price for it than we are paying the foreigners, or else we wouldn’t go to foreigners in the first place.

Moreover, we have a mechanism that handles the problem of a foreign supply cutoff that is similar to the mechanism that handles the conservation problem. That mechanism is called speculation. Speculation helps to take account of foreign supply cutoffs. We saw an example of that with coffee. When the coffee buds died, speculators knew that in a couple of years the price would be higher. Therefore, they withheld coffee today, raising the price now and encouraging people to consume less now. The coffee was saved for later when it would be valued more because it would be scarcer. The market was allowed to operate and it did its job nicely. There was no coffee shortage. And again there was the same incentive to have correct information. People won’t necessarily be correct in a free market, but at least they will have an incentive to be correct.

Now here’s a case where the speculator, though serving a very useful function, is hampered by price controls and by “windfall” profits taxes: with the 1973 oil embargo and the later quadrupling in prices by the Arabs, the price of oil shot up dramatically. But the government didn’t let the price of domestic oil go up all the way. People who were conserving, who made a right decision by holding all that oil, didn’t get the full reward for doing that. Their reward was called obscene windfall profits. Price controls throw a monkey wrench into the speculative function because if people can’t get the gain for having saved oil in abundant periods for more scarce periods, they are less inclined to do that. As a result we are more vulnerable to the Arabs.

I have spent much time criticizing current and proposed energy regulation. I think it only fair to discuss my own five proposals.

(1) Eliminate price controls. Effective price controls cause shortages. A persistent objection to the removal of price controls on oil and natural gas has been that the higher prices will hurt consumers. However, “it ain’t necessarily so.” Consumers who cannot buy gas or oil at controlled prices are already turning to substitutes, e.g., liquidified natural gas, that are now priced higher than the price of oil and natural gas would be without price controls. Whether they would lose from price decontrol would depend on the magnitude of their cost saving on price-controlled energy relative to the magnitude of their cost increase on higher-priced substitutes. Since these relative magnitudes vary among consumers, decontrol would benefit some consumers and hurt others. Since production is discouraged the longer price controls remain, the number of consumers helped by price controls decreases over time.

(2) Eliminate government energy standards for buildings, cars, or appliances. If consumers face the right (decon-trolled) price of energy, they will consume the appropriate amount of energy.

(3) Eliminate forced conversion of utilities to coal.

(4) Eliminate the Department of Energy. The budgetary cost alone of the DOE is over $200 per family.

(5) Eliminate sacrifices for the sake of sacrifice. Sacrifice is a bad, not a good. As Milton Friedman said of a Congressman’s statement that the Carter energy program was fine as long as everyone sacrificed equally, “What a sadistic philosophy!”

Some people would not object to my proposals if they believed that the oil industry would be competitive rather than a cartel in the absence of government controls. But, they claim, the oil industry is a cartel, that is, a number of firms that get together and act like a monopoly, by fixing a price and setting output quotas for each firm.

The oil cartel

There certainly is an oil cartel. It is called OPEC (the Organization of Petroleum Exporting Countries). We know it’s a cartel because demand was relatively stable and was growing a few percent a year and suddenly the price quadrupled. That rarely happens in a competitive market.

But this fact does not weaken my argument at all. It strengthens it, because many of the policies I have criticized strengthen the cartel. The U.S. government has really helped that cartel, and is trying harder to help it. The price controls on domestic oil discourage production of domestic oil. The price controls on natural gas discourage domestic natural gas production. People who cannot get natural gas or oil domestically will buy from foreigners, namely, from OPEC. So the government’s price controls are helping OPEC. The government helped OPEC for a few years by holding up the Alaska pipeline. It helped the cartel by imposing coal mine safety legislation which didn’t do much to increase safety but certainly did a lot to increase the cost of coal mining. Finally, a regulation that the Department of Energy adopted in 1977 has probably stabilized the cartel. The DOE now requires all domestic oil companies that deal with foreign oil companies to state at the end of each month the quantities they purchased from each of those countries and the prices paid. In antitrust law that was once called an open price trade association. The idea was to get a number of competitors together with each having a right to look at the others’ books. It is much easier to enforce a cartel when you do that. Each member of the OPEC cartel has an incentive to cheat by cutting price and increasing its sales. Even though their collective interest is to have a high cartel price, each individual member’s interest is to cut price. There has probably been a lot of price cutting. With the DOE regulation, there is probably less price cutting. Now OPEC gets, courtesy of the United States Government, information every month on who is cheating. And OPEC can take appropriate sanctions against cheaters.

Even in the absence of the OPEC cartel would the domestic oil industry be a cartel? I say no. There are two main reasons. One is that it is too difficult to collude. We have a large number of oil companies. There was a Union Oil ad in Newsweek in 1976 full of trademarks of companies in the oil industry. Many of them familiar: Shell, Gulf, Mobil, Fina, Total, Koch, and on and on and on, about 50 of them. Union Oil’s comment was “some way to run a cartel.” There are just too many of those companies around. They may have an incentive to get together and make a collusive agreement, but each of them has an incentive to cheat on that agreement and probably will.

But here is another even more convincing piece of evidence about why there is no cartel of U.S. oil companies and refiners. Just look at what OPEC did. It quadrupled oil prices, and the quantity sold fell somewhat, but not much. Revenues tripled. In economists’ terms, demand was highly inelastic. Costs fell somewhat because at that higher price OPEC sold less and therefore produced less. OPEC’s profits rose dramatically since revenues rose and costs fell. You needn’t be very smart to hire an economist to find out that the elasticity of demand for oil was very low. So if the oil companies were in a cartel, they would have increased the price long ago. They would have been crazy not to. Before the advent of price controls, they could have made all these higher profits too by simply increasing the price. They did not do so. Either we have to conclude that they’re stupid or that they’re not a cartel. The latter makes more sense to me.

There’s some apparent evidence for the idea that the oil and natural gas industries are successful cartels. But it is only apparent. The first piece of “evidence” is that oil companies made windfall profits in the billions back in 1973 and 1974 when the price went up. Of course they did. Whether you’re a monopolist or the Beverly Hillbillies with a thousand other competitors competing with you, if the price of some good of which you have an inventory rises, you’re going to make windfall profits. Windfall profits in themselves are not evidence at all that the firms making them are monopolists.

There’s another piece of apparent evidence for the cartel hypothesis, but it is not evidence either. That is the claim that in the last few years producers have been hoarding natural gas and oil. If they anticipate that the controlled price is going to be allowed to rise, they would be crazy to produce and sell at the lower price rather than wait until the price is allowed to rise. Collusion is not a necessary condition for hoarding. If there were a million producers and they all anticipated the price rise they would all withhold output now. That would happen whether they were monopolists or competitors. Incidentally, “hoarding” is just a nasty word for allocation over time. Without price controls, it is very useful.

I have analyzed the effects of government regulation. Past government regulation has been pernicious and the proposed government regulations will also be pernicious. I have also outlined the free market approach that is consistent with the classical liberal ideal of allowing people to make their own adjustments and exercise their own individuality in doing that. But there’s one issue that I haven’t devoted much time to and I want to conclude with it.

Given the fact that the energy “problem” can be dealt with effectively by individuals making their own choices, and that energy has become a special problem as a result of government intervention, why is anyone advocating further government intervention which would only compound the problem? That’s a tough question that no one has answered conclusively. But the fact that it hasn’t been answered should not prevent me from suggesting why certain mandarins in Washington favor further regulation. I can do no better than quote from an astute observer of government bureaucracy,

The tool of politics, which frequently becomes its objective, is to extract resources from the general taxpayer with minimum offense, and to distribute the proceeds among innumerable claimants in such a way to maximize the support at the polls. Politics, so far as mobilizing support is concerned, represents the art of calculated cheating—or more precisely, how to cheat without being really caught. Slogans and catch phrases . . . remain effective instruments of political gain. One needs a steady flow of attention grabbing cues and it is of lesser moment whether the indicated castles in Spain ever materalize.

Who wrote this? Some libertarian curmudgeon who hates bureaucracy? No. It was the same person who persuaded Jimmy Carter to use that slogan “the moral equivalent of war” in describing his energy program. His name? James R. Schlesinger.

David Henderson is an assistant professor of economics at the Graduate School of Management at the University of Rochester. He wishes to gratefully acknowledge research support in preparation of this article from the Center for Research in Government Policy and Business, University of Rochester.