A Detriment of the Public Service

This essay was selected from more than 260 entries in the Minneapolis Fed's 12^th annual essay contest for Ninth District high school juniors and seniors. When the essay question was initially posed and the image selected, the Minneapolis Fed did not foresee the rise in gasoline prices early this spring. All the same, the topic was indeed timely.

"... it hath been found by experience that limitations upon the prices of commodities are not only ineffectual for the purposes proposed, but likewise productive of very evil consequences to the great detriment of the public service and grievous oppression of individuals ... "--Continental Congress, 1778.¹

In the wake of Watergate and the Yom Kippur war, Don Roberts, a middle-aged gas station attendant from Minneapolis was hit with a crisis closer to home: the Arab Oil Embargo. For months, Roberts had labored in supplying long gas lines and disgruntled consumers with fuel, only to find that on Dec. 19, 1973, he was without a product to sell. Arms raised in acquiescence, he conceded: "Sorry! Out of Gas." The problems faced by Roberts were a result of a failure in the American free market system to properly allocate its resources. Detrimental government influence of quantity demanded combined with collusive supply withholding added fuel to a firestorm that might otherwise have been a mere spark. The predicament faced by Roberts and thousands of other gasoline retailers illustrates the adverse effect of interference with free market mechanisms, ultimately helping policymakers shape their decisions for the future and avoiding similar market failures.

The economic spiral resulting in gas shortages began on Jan. 11, 1973, with the institution of anti-inflationary Phase III price controls.² Phase III, unlike its two predecessors, was a voluntary freeze on prices. Encouraged by winter demand, the domestic petroleum giants increased their prices of heating oil by 8 percent and began rampant production.³ However, heating oil production left refiners unable to prepare gasoline stocks for heavy summer demand,⁴ later exacerbating the gas shortage. To punish the oil companies, the Cost of Living Council issued Special Rule #1 in March 1973, reimposing mandatory Phase II price controls on 95 percent of the domestic petroleum market.⁵ This action, freezing the price of petroleum for all but independent refiners, prevented gas prices from reaching a market-based supply and demand equilibrium.

The effect of petroleum price limitations became compounded when the Organization of Petroleum Exporting Countries (OPEC) met on Oct. 17, 1973.⁶ During this Kuwait City meeting, OPEC delegates recommended "that the United States be subjected to the most severe cuts"⁷ to punish America's support of Israel. The resulting OPEC embargo cut 5 percent of petroleum production per month until Israel pulled out of the Arab territories it was occupying.⁸ Despite OPEC's ruling, President Nixon proposed a $2.2 billion aid package for Israel. Saudi Arabia, infuriated, cut off all shipments of oil to the United States on Oct. 20.⁹ Although Mideast oil only accounted for 11 percent of U.S. consumption in 1972, by 1973 the level had risen to 18 percent.¹⁰ The increase in American dependence combined with a 470 percent increase in OPEC oil prices between January and December 1973¹¹ plunged the United States into a full-fledged crisis.

Had the American market been allowed to operate without price controls, the OPEC cutbacks would not have created a shortage of gasoline. As it was, the government set a motor gasoline price ceiling of approximately 46 cents.¹² Refiners were less willing to produce as much gasoline because of the low ceiling price. If the price had been higher, output would have increased because "nothing brings on production like high prices."¹³

Conversely, consumers were more willing to buy more gas at the lower ceiling price than if a higher equilibrium price had been achieved. These factors created an output shortage of 2.7 million barrels of oil a day, or 13 percent of consumer demand.¹⁴ Gas lines, angry customers, and dry pumps were the result. In the Eastern Canadian provinces the story was much different. These provinces were much more dependent on imported oil than the United States, but did not impose any price controls on petroleum, allowing gas prices and output to reach an equilibrium position. The market cleared at a reasonable 59 cents a U.S. gallon,¹⁵ not far off from Milton Friedman's market-clearing U.S. estimate of 55 cents.¹⁶

Policymakers today can learn from the failure of the U.S. government in solving the oil crisis of the 1970s by unequivocally adhering to laissez-faire principles. Today, as the United States is once again faced with rising gasoline prices due to OPEC withholding petroleum supply, economists are reiterating support for free market mechanisms. Government needs to adhere to these economically correct solutions and not be seduced by more popular politically correct solutions, as occurred in 1973. Allowing gas markets to reach equilibrium output and price levels will prevent gas lines and dry pumps. The Clinton administration has done a fine job in allowing free oil markets, but if gas prices become too high, the Strategic Oil Reserves should be opened to increase the supply available to refiners, barring a major crisis. However, as with any collusive oligopoly, eventually an OPEC member will begin to increase production and sell at a lower price to increase its profits. Other members will follow, increasing supply, and oil prices will fall. The market will have been cleared with a fraction of the problems incurred in 1973.

Unfortunately, 20 years after a price ceiling on gasoline left Don Roberts' pumps dry, government price controls are adversely affecting the pharmaceutical industry.¹⁷ Government again is ignoring economists because politicians want lower prices for their constituents. Such a policy is shortsighted. Virginia Ladd, president of the American Autoimmune Related Diseases Association, explains, "caps on drug prices won't just hurt ... research companies ... [but] some 50 million Americans with serious diseases."¹⁸ The key, as in 1973, is to let the free market system operate without interference. Only a commitment by the government to take a long-term economic view will allow this. Don Roberts and his pharmaceutical counterparts would agree with economist David Kreutzer of James Madison University: "We learned from the 1970s that price controls are very costly, ineffective, and ultimately, disfavored. The quack who pushes snake-oil economics had better ... leave town."¹⁹

Footnotes

¹ "Price Controls Throughout History: What Experts Have Said." Pharma. Online posting. www.phrma.org/.

² Allen J. Matusow, Nixon's Economy (1998), 248.

³ Ibid.

⁴ Oil and Gas Journal (March 19, 1973), 27-30.

⁵ "World Oil Market and Oil Price Chronologies." United States Energy Information Administration. Online posting. www.eia.doe.gov.

⁶ Daniel Yergin, The Prize (1991), 607.

⁷ Ibid.

⁸ "Multinational Oil Corporations," Senate Report, 144-145.

⁹ Henry Kissinger, Years of Upheaval, 873.

¹⁰ U.S. Department of Energy, Energy Information Administration, 1980 Annual Report, 49, Table 21.

¹¹ Matusow, 263.

¹² Matusow, 266.

¹³ Editorial, Fortune Magazine (December 1973), 79-80.

¹⁴ William Simon, "Current Energy Shortages Series: The Federal Energy Office," Government Operations Committee, Senate Hearings (1974), 605.

¹⁵ Matusow, 266.

¹⁶ Milton Friedman, Newsweek (Nov. 19, 1973), 130.

¹⁷ "Why Pharmaceutical Price Controls are Bad for Patients." American Enterprise Institute for Policy Research. Online posting. www.aei.org.

¹⁸ See 1.

¹⁹ Ibid.