The story

Price Controls


From time immemorial, governments have tried to set minimum or maximum prices on goods. Recent history indicates that governments have fixed the price of gasoline, rent, and the minimum wage, to name a few, with war usually the reason for general price controls.A price ceiling will prevent prices from exceeding a certain maximum and will cause shortages. Price floors, on the other hand, will prohibit prices falling below a minimum, thus creating surpluses.Controls hold out the promise of protecting groups of consumers, especially those having difficulty adjusting to price changes. While controls on prices normally distort allocation of resources, economists usually know how to produce a surplus or a shortage in order to fight inflation and eventually establish a stable economy.Following the bombing of Pearl Harbor in 1941 and with the onset of World War II, the federal government set out to impose new or expanded controls over the country`s economy. On January 6, 1942, President Franklin D. Roosevelt announced some ambitious production goals to support the war. While economists usually oppose price controls, it was a state of emergency.The government then sought the cooperation of those who controlled the resources needed to conduct the war successfully. It took many agencies to resolve disputes between workers and management, set price controls, and impose rationing on scarce commodities as part of the war effort. Such agencies as the War Production Board (WPB) and the Office of Price Administration (OPA) were created in 1942 to increase total production and to control wages and prices.Wage and price control measures, as well as regulating the hiring and firing of workers, was also initiated by the government. The National War Labor Board was established by an executive order of President Roosevelt on January 12, 1942. It was also authorized to approve wage increases and quickly adopted the Little Steel formula for wartime changes based on the rising cost of living.The Emergency Stabilization Act was passed in October 1942, which placed wages and agricultural prices under control. Controlling output proved easier than controlling wages.The Office of War Mobilization then emerged in 1943 to reallocate the production of military matériel. The great surge in munitions production reached its peak in 1943, after such motives as patriotism and financial incentives drew the necessary resources to war production centers.In June 1943, the OPA established more than 200 Industry Advisory Committees whose sole purpose was to aid the price control effort. Strict limits were set on the manufacture of numerous consumer goods.The public supported price controls, and businesses supported them even before they were implemented. With their cooperation came an increase in union membership, which resulted in a general decrease in labor militancy.Despite the efforts of the National War Labor Board, the shortage of labor during World War II precipitated a sharp increase in wages. Although strikes were prohibited, they still occurred.Social Security also was affected by the price controls. With the war there was a revolution within government finances: Revenue demands led directly to a large increase in income tax rates and withholding on individuals.During the war, a positive measure began for some when the federal government stimulated and controlled the course of private industry by offering low-interest loans, generous tax credits and guaranteed purchase contracts for business ventures. In some cases the government went to great lengths to construct factories, then hand them over to private interests to operate.Rent control was another factor. Many economists agree that rent controls are destructive.With war came the rationing of food and more price controls. Unfortunately in some cases, that created artificial scarcity and people under the system suffered substantially.With the adoption of the Employment Act of 1946, the federal government for the first time acknowledged an ongoing responsibility for formulating budgets that would help maintain high levels of employment. Fringe benefits became more common during the late 1940s as part of the settlements reached in collective bargaining.By the fall of 1946, most federal price controls had been lifted. With the onset of war, the American people made various adjustments to price controls that may still indirectly affect people today.On August 15, 1971, President Richard M. Nixon announced that the United States was abandoning the gold standard and imposed a 90-day freeze on prices and wages.


Nixon shock

The Nixon shock was a series of economic measures undertaken by United States President Richard Nixon in 1971, in response to increasing inflation, the most significant of which were wage and price freezes, surcharges on imports, and the unilateral cancellation of the direct international convertibility of the United States dollar to gold. [1]

While Nixon's actions did not formally abolish the existing Bretton Woods system of international financial exchange, the suspension of one of its key components effectively rendered the Bretton Woods system inoperative. While Nixon publicly stated his intention to resume direct convertibility of the dollar after reforms to the Bretton Woods system had been implemented, all attempts at reform proved unsuccessful. By 1973, the Bretton Woods system was replaced de facto by the current regime based on freely floating fiat currencies. [2]


Example of a Price Ceiling: Rent Control

Rent control is a common type of price ceiling that large municipalities, such as New York City, often impose to make housing more affordable for low-income tenants. Over the short run, the supply for apartments is inelastic, since the quantity of buildings already supplied is constant, and those being constructed will continue to be constructed because of sunk costs.

Over the long-run however, rent control decreases the availability of apartments, since suppliers do not wish to spend money to build more apartments when they cannot charge a profitable rent. Landlords not only do not build any more apartments, but they also do not maintain the ones they have, not only to save costs, but also because they do not have to worry about market demand, since there is excessive demand for rent-controlled apartments. Hence, excess demand and limited supply leads to a large shortage.


NaturalGas.org

Regulation of the natural gas industry in the United States has historically been a tumultuous ride, resulting in dramatic changes in the industry over the past 30 or more years. This section will outline the major historical regulatory events related to the natural gas industry, and show how the current structure of the industry in the U.S. is the product of a long regulatory evolution.Today, competitive forces are being relied upon more heavily to determine market structure and operation. However, this has not always been the case. Almost all aspects of the natural gas industry were regulated at one point – a situation which led to tremendous difficulties in the industry, including the natural gas shortages experienced in the 1970s. To learn more about the current regulatory environment, click here.

This section provides a timeline of important regulatory events regarding the natural gas industry. Click on the links below to skip ahead to later sections:

Click here to view a condensed timeline of important regulatory developments.

The Early Days of Regulation

The regulation of natural gas dates back to the very beginnings of the industry. In the early days of the industry (mid-1800s) natural gas was predominantly manufactured from coal, to be delivered locally, generally within the same municipality in which it was produced. Local governments, seeing the natural monopoly characteristics of the natural gas market at the time, deemed natural gas distribution a business that affected the public interest to a sufficient extent to merit regulation. Because of the distribution network that was needed to deliver natural gas to customers, it was decided that one company with a single distribution network could deliver natural gas more cheaply than two companies with overlying distribution networks and markets. However, economic theory dictates that a company in a monopoly position, with total control over its market and the absence of any competition will typically take advantage of its position, and has incentives to charge overly-high prices. The solution, from the point of view of the local governments, was to regulate the rates these natural monopolies charged, and set down regulations that prevented them from abusing their market power.

As the natural gas industry developed, so did the complexity of maintaining regulation. In the early 1900s, natural gas began to be shipped between municipalities. Thus natural gas markets were no longer segmented by municipal boundaries. The first intrastate pipelines began carrying gas from city to city. This new mobility of natural gas meant that local governments could no longer oversee the entire natural gas distribution chain. There was, in essence, a regulatory gap between municipalities. In response to this, state level governments intervened to regulate the new ‘intrastate’ natural gas market, and determine rates that could be charged by gas distributors. This was done by creating public utility commissions and public service commissions to oversee the regulation of natural gas distribution. The first states to do so were New York and Wisconsin, which instituted commissions as early as 1907.

Interstate Pipelines Spurred
Federal Regulation
Source: Duke Energy Gas Transmission Canada

The Beginnings of Federal Regulatory Involvement

With the advent of technology that allowed the long distance transportation of natural gas via interstate pipelines, new regulatory hurdles arose. In the same sense that municipal governments were unable to regulate natural gas distribution that extended beyond their areas of jurisdiction, the state governments were unable to regulate interstate natural gas pipelines. Between 1911 and 1928, several states attempted to assert regulatory oversight of these interstate pipelines. However, in a series of decisions, the U.S. Supreme Court held that such state oversight of interstate pipelines violated the interstate commerce clause of the U.S. Constitution. These cases, known as the ‘Supreme Court Commerce Clause’ cases, essentially stated that interstate pipeline companies were beyond the regulatory power of state-level government. Without any federal legislation dealing with interstate pipelines, these decisions essentially left interstate pipelines completely unregulated the second regulatory gap.

However, due to concern regarding the monopoly power of interstate pipelines, as well as conglomeration of the industry, the federal government saw fit to step in to fill the regulatory gap created by interstate pipelines.

In 1935, the Federal Trade Commission issued a report outlining its concern over the market power that may be exerted by merged electric and gas utilities. By this time, over a quarter of the interstate natural gas pipeline network was owned by only 11 holding companies companies that also controlled a significant portion of gas production, distribution, and electricity generation. In response to this report, in 1935 Congress passed the Public Utility Holding Company Act to limit the ability of holding companies to gain undue influence over a public utility market. However, the law did not cover the regulation of interstate gas sales. Click here to view the Public Utility Holding Company Act as it exists today.

The Natural Gas Act of 1938

In 1938, the federal government became involved directly in the regulation of interstate natural gas with the passage of the Natural Gas Act (NGA). This act constitutes the first real involvement of the federal government in the rates charged by interstate gas transmission companies. Essentially, the NGA gave the Federal Power Commission (the FPC, which had been created in 1920 with the passage of the Federal Water Power Act) jurisdiction over regulation of interstate natural gas sales. The FPC was charged with regulating the rates that were charged for interstate natural gas delivery, as well as limited certification powers. The NGA specified that no new interstate pipeline could be built to deliver natural gas into a market already served by another pipeline. In 1942, these certification powers were extended to cover any new interstate pipelines. This meant that, in order to build an interstate pipeline, companies must first receive the approval of the FPC.

The rationale for the passage of the NGA was the concern over the heavy concentration of the natural gas industry, and the monopolistic tendencies of interstate pipelines to charge higher than competitive prices due to their market power. While the NGA required that ‘just and reasonable’ rates for pipeline services be enforced, it did not specify any particular regulation of prices of natural gas at the wellhead.

To learn more about the Natural Gas Act, click here.

The Phillips Decision – Wellhead Price Regulation

As mentioned, the NGA instituted no specific regulatory oversight of sales of natural gas from producers to the pipelines: wellhead prices were unregulated. However, in Supreme Court cases during the early 1940s, it was determined that wellhead prices were subject to federal oversight if the selling producer and the purchasing pipeline were affiliated companies. However, the FPC contended that if the natural gas producer and pipeline were unaffiliated, natural market forces existed that would keep wellhead prices competitive.

Phillips – Wellhead Price Regulation
Source: NGSA

In 1954, however, this all changed with the Supreme Court’s decision in Phillips Petroleum Co. v. Wisconsin (347 U.S. 672 (1954)). In this decision, the Supreme Court ruled that natural gas producers that sold natural gas into interstate pipelines fell under the classification of ‘natural gas companies’ in the NGA, and were subject to regulatory oversight by the FPC. This meant that wellhead prices – that is, the rate at which producers sold natural gas into the interstate market – would be regulated much the same as natural gas that was sold by interstate pipelines to local distribution utilities.

The Phillips decision had a complicated and far-reaching effect on the natural gas industry. In regulating wellhead prices, the FPC instituted a traditional ‘cost-of-service’ rate making determination. This system of setting rates relied on the cost of providing the service, rather than the market value of that service. This meant that prices were set to allow companies to charge prices high enough to cover the actual costs of producing natural gas, plus a ‘fair’ profit. Where regulating pipelines had been possible with this method due to the relatively small number of interstate pipeline companies, the large number of different natural gas producers meant that regulating producers was an extreme administrative burden for the FPC. Three eras of producer regulation ensued each with its own difficulties, until finally wellhead price control culminated in the natural gas shortages of the 1970s.

From 1954 to 1960, the FPC attempted to deal with producers and their rates on an individual basis. Each producer was treated as an individual public utility, and rates were set based on each producer’s cost of service. However, this turned out to be administratively unfeasible, as there were so many different producers and rate cases that a tremendous backlog developed at the FPC. For example, in 1959, there were 1,265 separate applications for rate increases or reviews, the FPC was only able to act on 240 cases.

Due to this enormous backlog, the FPC in 1960 decided to set rates based on geographic areas. The U.S. was divided into five separate producing regions, and the FPC set rates for all wells in a particular region. The FPC set interim ceiling prices based on the average natural gas contract prices paid during 1959-1960 for a particular area. The FPC intended on using these interim ceiling prices until it could determine a ‘just and reasonable’ rate that it could apply to all natural gas sales from a particular region. However, the process for determining area wide rates took much longer and was much more difficult than anticipated, and by 1970 rates had been set for only two of the five producing areas. To make matters worse, for most of the areas, prices were essentially frozen at 1959 levels. The problem with determining rates for a particular area based on cost-of-service methodologies was that there existed many wells in each area, with vastly different production costs.

By 1974, the FPC had determined that area wide pricing was unfeasible. In an effort to find a system of wellhead price regulation that worked, the FPC adopted national price ceilings for the sale of natural gas into interstate pipelines. Realizing that the prior price ceilings, based on the cost-of-service approach, were much lower than the market value of interstate natural gas, the FPC set a national price ceiling of .42 per million cubic feet (mcf) of natural gas. Although this price ceiling doubled the prices that had been set during the 60s, it was still significantly less than the market value of the natural gas being sold. This system of price controls was in place until the passage of the Natural Gas Policy Act (NGPA) in 1978.

The Effects of Wellhead Price Controls 1954-1978

All three of these systems of price control discussed above had disastrous effects on the natural gas market in the United States. The artificially low price ceilings that had been set since 1954 had a number of outcomes in the market, coming to bear in the late 60s and 70s. Because the set rates for natural gas were below the market value of that gas, demand surged. The low prices of natural gas, as set by the FPC, meant that consumers were receiving good value for their money. This combined with the oil price surges experienced during the OPEC crisis in the 70s made natural gas an even more attractive fuel.

However, at the same time, there was little incentive for natural gas producers to devote the money required to explore for and produce new natural gas reserves. The selling price for natural gas was so low, it simply wasn’t worth it for the producers. Producers also saw little incentive to search for new reserves. While the price at which they could sell interstate gas was fixed, the finding and development costs for establishing new reserves was as variable and unpredictable as ever. Producers saw little reason to engage in the exploration of new reserves that would cost more to find than they could be sold for under FPC wellhead price control.

However, the FPC only regulated producer wellhead prices for natural gas destined for the interstate market, leaving natural gas sales within the intrastate market relatively free of regulation. So while demand was surging nationwide, economic incentives did not exist for producers to ship their gas across state lines. They could sell it at a much higher price to intrastate bidders. In 1965, a third of the nations proved reserves were earmarked for intrastate consumers by 1975, almost half of the proved reserves were committed to intrastate consumers.

This resulted in natural gas reaching consumers in the producing states, while the consuming states were experiencing natural gas supply shortages. In fact, in 1976 and 1977, many schools and factories in the Midwest were forced to close, due to a shortage of natural gas to run their facilities. Meanwhile, in the producing states, virtually no shortage was felt, due to the thriving intrastate market satisfying natural gas demand in these states. This led to certain ‘curtailment’ policies, advocated by the FPC and state utility regulators. These policies essentially set a schedule of priority, directing distributors and transporters to curtail supplies to certain customers who were deemed ‘low priority’. However, these policies resulted in numerous litigation suits and FPC proceedings that turned out to be extremely complicated and time consuming. Realizing that something must be done at the federal level to reduce the strain of these supply shortages and demand surges, Congress enacted the Natural Gas Policy Act in 1978.

The Natural Gas Policy Act of 1978

In November of 1978, at the peak of the natural gas supply shortages, Congress enacted legislation known as the Natural Gas Policy Act (NGPA), as part of broader legislation known as the National Energy Act (NEA). Realizing that those price controls that had been put in place to protect consumers from potential monopoly pricing had now come full circle to hurt consumers in the form of natural gas shortages, the federal government sought through the NGPA to revise the federal regulation of the sale of natural gas. Essentially, this act had three main goals:

  • Creating a single national natural gas market
  • Equalizing supply with demand
  • Allowing market forces to establish the wellhead price of natural gas

This act attempted to accomplish these goals by statutorily setting ‘maximum lawful prices’ for the wellhead sale of natural gas, as well as breaking down barriers between intrastate and interstate natural gas markets. The FPC, the federal body with regulatory oversight of the natural gas market, was abolished and replaced with another body, the Federal Energy Regulatory Commission (FERC), under the Department of Energy Organization Act of 1977. Under the NGPA, FERC was given jurisdiction over the same areas as the FPC, with the exception of the import and export of natural gas, which was the jurisdiction of the new Department of Energy.

The ceiling prices for wellhead gas set by the NGPA differed from the system put in place under the NGA. Under the NGPA, increased price ceilings were set, intended to provide economic incentives for producers to search for and produce new natural gas. These ceilings and the mechanisms for increasing rates were set out in the statute, rather than relying on an independent body to determine these rates. Under the NGPA, some of the price ceilings that were set, specifically those affecting wellhead sales of new production, were designed to be phased out over a series of years, with the goal of complete deregulation of wellhead prices by 1985. However, the NGPA also dictated that gas brought into production before the passage of the Act would forever be subject to pre-NGPA regulations and price limits.

In addition to this new system for rate-setting, and the goal of deregulation of wellhead prices in seven years, the NGPA also served to break down the barriers between interstate and intrastate natural gas. Under the NGPA, FERC was authorized to approve the transportation of natural gas by an interstate pipeline on behalf of intrastate pipelines and local distribution companies – avoiding some of the regulatory hurdles that had created such a schism between interstate and intrastate markets.

The NGPA was a fundamental first step in deconstructing the regulatory problems that had been created by the NGA. The market response to the provisions of the NGPA included:

  • Pipelines, accustomed to gas shortages in the past years, signed up for many long-term natural gas contracts
  • Producers expanded exploration and production, drilling new wells and using the long-term sales contracts with pipelines to recover their investment
  • Average wellhead prices rose dramatically in the years following the NGPA
  • Prices for end-users increased, but were mitigated by the pipelines, which blended the cost of gas under new contracts with regulated gas under old contracts when selling their bundled product to their customers
  • Price increases led to decreased demand

Thus the NGPA allowed for more competitive prices at the wellhead. However, many members of the industry were unprepared for the corresponding drop in demand. The pipelines, used to the era of curtailment, were quick to sign up for long-term ‘take-or-pay’ contracts. These contracts required the pipelines to pay for a certain amount of the contracted gas, whether or not they can take the full contracted amount. While the NGPA did spur investment in the discovery of new natural gas reserves, the increasing wellhead price, mixed with the eagerness of pipelines to deliver as much natural gas as possible, led to a situation of oversupply.

Where it was necessary to curtail natural gas deliveries in the 60s and 70s due to high demand and low supply, the situation reversed in the period from 1980-85. Rising natural gas prices resulted in the dropping off of some of the demand that had built up when the price for natural gas was held below its market value. The resulting ‘oversupply’ scenario had a number of effects, including requiring the pipelines to make ‘take-or-pay’ payments to their suppliers despite no longer needing the amount of natural gas that had previously been contracted. Customers of the pipelines, purchasing a ‘bundled’ product – including the natural gas itself and the transportation of that gas – lobbied for reduced natural gas prices. In addition, pipeline customers sought the right to purchase their own gas from producers and transport it over the interstate pipelines, instead of purchasing the bundled product directly from the pipelines.

To learn more about the Natural Gas Policy Act, click here.

The Move towards Deregulation

The Natural Gas Policy Act took the first steps towards deregulating the natural gas market, by instituting a scheme for the gradual removal of price ceilings at the wellhead. However, there still existed significant regulations regarding the sale of gas from an interstate pipeline to local utilities and local distribution companies (LDCs). Under the NGA and the NGPA, pipelines purchased natural gas from producers, transported it to its customers (mostly LDCs), and sold the bundled product for a regulated price. Instead of being able to purchase the natural gas as one product, and the transportation as a separate service, pipeline customers were offered no option to purchase the natural gas and arrange for its transportation separately.

Several events led up to the ‘unbundling’ of the pipelines’ product. In the early 1980s, noticing that a significant number of industrial customers were switching from using natural gas to other forms of energy (for example, electric generators switching from natural gas to coal), several pipelines instituted what they called Special Marketing Programs (SMPs). Essentially, these programs, which were approved by FERC, allowed industrial customers with the capability to switch fuels the right to purchase gas directly from producers, and transport this gas via the pipelines. However, SMPs were found discriminatory by the District of Columbia Circuit Court of Appeals in several 1985 cases. The court ruled that SMPs were discriminatory in that no other customer of the pipelines had the ability to purchase their own natural gas and transport it via pipeline. As a result of this, SMPs were eliminated on October 31, 1985.

However, the practice of allowing customers to purchase their own gas, and use pipelines only as transporters rather than merchants, was not abandoned. In fact, it became part of FERC policy to encourage this separation by way of Order No. 436.

In 1985, FERC issued Order No. 436, which changed how interstate pipelines were regulated. This order established a voluntary framework under which interstate pipelines could act solely as transporters of natural gas, rather than filling the role of a natural gas merchant. This order provided for all customers the same possibilities that the SMPs of the early 1980s had afforded industrial fuel-switching customers, thus avoiding the discrimination problems of the earlier SMPs. Essentially, FERC allowed pipelines, on a voluntary basis, to offer transportation services to customers who requested them on a first come, first served basis. The interstate pipelines were barred from discriminating against transportation requests based on protecting their own merchant services. Transportation rate minimums and maximums were set, but within those boundaries the pipelines were free to offer competitive rates to their customers. Although the framework established by Order 436 was voluntary, all of the major pipeline systems eventually took part.

FERC Order No. 436 had a number of immediate effects, including:

  • Pipelines began offering transportation service to all customers
  • Pipeline customers realized cost savings, in that the spot market prices of natural gas were much lower than the prices offered for natural gas by the pipelines (due to the long term ‘take-or-pay’ contracts that the pipelines were bound under)
  • The payments necessary under these ‘take-or-pay’ contracts increased for pipelines, as few customers were willing to purchase higher priced gas from the pipelines
  • Pipelines and producers were often forced into litigation to resolve issues surrounding ‘take-or-pay’ contracts

FERC Order No. 436 also had a number of longer term effects, including:

  • The transportation function became the primary function of pipelines, as opposed to offering the bundled merchant service
  • A wide variety of natural gas purchasing and transportation patterns and practices emerged due to the availability of choices to the end user
  • New pricing patterns emerged, known as ‘netback’ pricing, in which a reasonable price was set at the point of consumption, and that minus the cost of distribution, minus the cost of transportation, gave the ‘netback’ price to the producer at the wellhead

The movement towards allowing pipeline customers the choice in the purchase of their natural gas and their transportation arrangements became known ‘open access’. Order No. 436 thus became generally known as the Open Access Order.

While the general thrust of Order 436 was upheld in Court, several problems arose regarding the ‘take-or-pay’ contracts under which the pipelines were still obliged. Given these problems, and under remand from the D.C. Circuit Court of Appeals, FERC issued Order No. 500 in 1987. This order essentially encouraged interstate pipelines to buy out the costly take-or-pay contracts, and allowed them to pass a portion of the cost of doing so through to their sales customers. The LDCs to which these costs were passed through were allowed by state regulatory bodies to further pass them on to retail customers. However, the open access provisions of Order No. 436 remained intact.

Open access to pipelines also spurred the first appearances of natural gas marketers. To learn more about natural gas marketing, click here.

The Natural Gas Wellhead Decontrol Act of 1989

As mentioned, under the NGPA, the deregulation of natural gas producers sale prices at the wellhead had begun. However, it wasn’t until Congress passed the Natural Gas Wellhead Decontrol Act (NGWDA) in 1989 that complete deregulation of wellhead prices was carried forth. Under the NGWDA, the NGPA was amended and all remaining regulated prices on wellhead sales were repealed. As of January 1, 1993, all remaining NGPA price regulations were to be eliminated, allowing the market to completely determine the price of natural gas at the wellhead.

The NGWDA stated that ‘first sales’ of natural gas were to be free of any federal price regulations. The Act defined ‘first sales’ as the sale of gas:

  • To a pipeline
  • To a local distribution company
  • To an end user
  • Preceding the sale to any of the above
  • Determined by FERC to be a first sale

Excluded from falling under the definition of a first sale were any sales of gas by pipelines and local distribution companies, including interstate pipelines.

While FERC Order No. 436 made the unbundling of pipeline services possible, the establishment of transportation only services by a pipeline continued to be only voluntary. FERC Order No. 636 completed the final steps towards unbundling by making pipeline unbundling a requirement. Issued in 1992, the Order states that pipelines must separate their transportation and sales services, so that all pipeline customers have a choice in selecting their gas sales, transportation, and storage services from any provider, in any quantity. Order 636 is often referred to as the Final Restructuring Rule, as it was seen as the culmination of all of the unbundling and deregulation that had taken place in the past 20 years. Essentially, this Order meant that pipelines could no longer engage in merchant gas sales, or sell any product as a bundled service. This Order required the restructuring of the interstate pipeline industry the production and marketing arms of interstate pipeline companies were required to be restructured as arms-length affiliates. These affiliates, under Order 636, could in no way have an advantage (in terms of price, volume, or timing of gas transportation) over any other potential user of the pipeline.

FERC Order No. 636 is the culmination of deregulating the interstate natural gas industry. Distilled to its main purpose, the Order gives all natural gas sellers equal footing in moving natural gas from the wellhead to the end-user or LDC. It allows the complete unbundling of transportation, storage, and marketing the customer now chooses the most efficient method of obtaining its gas.

Order 636 also requires that interstate pipelines offer services that allow for the efficient and reliable delivery of natural gas to end users. These services include the institution of ‘no-notice’ transportation service, access to storage facilities, increased flexibility in receipt and delivery points, and ‘capacity release’ programs. No-notice transportation services allow LDCs and utilities to receive natural gas from pipelines on demand to meet peak service needs for its customers, without incurring any penalties. These services were provided based on LDC and utility concerns that the restructuring of the industry may decrease the reliability needed to meet their own customers’ needs. The capacity release programs allow the resale of unwanted pipeline capacity between pipeline customers. Order 636 requires interstate pipelines to set up electronic bulletin boards, accessible by all customers on an equal basis, which show the available and released capacity on any particular pipeline. A customer requiring pipeline transportation can refer to these bulletin boards, and find out if there is any available capacity on the pipeline, or if there is any released capacity available for purchase or lease from one who has already purchased capacity but does not need it.


History 101: Price controls don't work

For decades, the price and availability of gas has generated political heat. As a former Nixon administration official, I've been there and seen that. But what is surprising is the unwillingness of some in today's Congress to learn from our mistakes. Bills in the Senate and House today want to impose price controls on gasoline.

For those with memories shorter than mine, President Richard M. Nixon imposed wage and price controls on Aug. 15, 1971. Oil and gas were two of many commodities affected. An initial 90-day freeze turned into more than 1,000 days before the controls were dismantled. Inflation -- just above 4 percent in 1971 -- was in double digits when the controls were lifted.

Nixon kept the wage-and-price controls on oil, gasoline and petroleum products in place, as did Presidents Gerald Ford and Jimmy Carter. The results were disastrous. Oil exploration and domestic oil production slowed sharply. And foreign oil poured into the nation's gas tanks, filling the booming demand for price-controlled gas.

Thanks to this misguided policy, gasoline lines snaked along highways for hours during oil crises in the mid- and late-1970s. Stations ran out of gasoline and laws told consumers which days they could purchase gas. A windfall-profits tax compounded all the negative effects, and the shortages lasted until President Ronald Reagan repealed controls in 1981. The price of a gallon of gas at the pump fell by a third over five years.

With this kind of record, you might wonder what Congress is doing considering price controls and windfall profits taxes on gasoline. The Federal Trade Commission has repeatedly cautioned against reverting to this failed policy, warning: "If natural price signals are distorted by price controls, consumers ultimately might be worse off, as gasoline shortages could result." Artificial price caps ignore market forces and result in shortages during times of increased demand. Take the controls off to alleviate the shortages and prices rise higher than when controls went on.

A quarter century after the failed policy was repealed, the biggest determinant of prices at the pump is global and local supply and demand crude oil and petroleum are internationally traded products. Then there's government. On average, state and federal taxes account for about 46 cents on the gallon. Typically, refining, marketing and transportation account for more than a quarter of the price.

The market price of oil and gas cannot be "controlled" by governments, corporations or consumers. Following Hurricanes Katrina and Rita, the Gulf region's energy infrastructure was badly damaged. At the height of the U.S. drilling season in 2005, Katrina shut down platforms that produced one-sixth of America's domestic oil supplies. Ports that are conduits for almost a third of U.S. oil imports and refineries that process almost a third of the nation's oil supply were down. As a result, gasoline prices then hit $3.05, up $1.20 from 12 months earlier.

After Katrina, while the market encouraged everyone to cut back, there were no 1970s-style gas lines or closed stations elsewhere in the nation.

Other producers -- domestic and international -- were motivated by higher prices to take up the slack. In fact, oil exploration drilling is at a 20-year high and expenditures are at an all-time high. That's how markets work.

A Federal Trade Commission study, following Hurricanes Katrina and Rita, confirmed that common-sense conclusion. The FTC concluded that the market worked well -- without evidence of price gouging or illegal market manipulation -- and that price controls would have made the situation worse.

Drawing on experiences of the 1970s, the FTC concluded that price controls meant "gasoline shortages could result," leaving consumers worse off.

The history lesson for this Congress could not be clearer. Price controls could create shortages and leave our economy dangerously exposed to disruptions in supply. In the 1970s, we were the only nation on Earth to have gas lines. Why would anyone ever want to go back to that?

Jack Rafuse is a former energy adviser to the Nixon administration and currently heads Rafuse Consulting, which represents a variety of clients, including energy companies. He also is an independent consultant on energy and trade issues.


A Short History of Gasoline Price Controls

In the Weekend Interview in today’s Wall Street Journal (WSJ editor Rob Pollock interviews George Shultz), Shultz says the following:

And one thing you know from experience is when you control the price of something, you end up getting less of it. So if you control the price of health-care providers, you will have fewer of them and that’s gonna wind up as a crisis. The most vivid expression of that . . . was Jimmy Carter’s gas lines.

There’s nothing incorrect about this statement. But it gives the reader the impression that Jimmy Carter was the president who introduced price controls. Shultz knows better. It was his boss, Richard Nixon, who introduced price controls on everything and kept them on gasoline. Shultz, as Secretary of the Treasury at the time, was intimately involved with the details. It’s true that Carter kept the controls and didn’t try to get rid of them until early 1980, when he made a compromise with Congress–giving them their “windfall profits tax” on oil, which was really a graduated excise tax on oil, in return for phasing out the controls. But Nixon is the one who imposed them. So there were “Richard Nixon’s gas lines” just as there were “Jimmy Carter’s gas lines.”

You could dismiss Shultz’s line as simply a selective partisan dig, which is what it was. But I point this out because I have read over the years so many people blame Carter for price controls on gasoline as if Carter initiated them. Nixon started them, Ford kept them and made them worse with the so-called “entitlement program,” and Carter kept them. And, as noted above, Carter at least did try to get rid of them. Reagan finished the job within his first month in office.


Price Controls and Their Effects

Read pages 72-78 in the textbook, "The Economics of Price Controls" for this section.

When addressing market failure, one common perception of a problem is that the equilibrium price in a non-regulated market is not fair. Now, we have spent a lot of time in this course talking about "positive" and "normative" questions, and the notion of whether something is "fair" or not is manifestly a normative question. We do not have a reasonable and consistent definition of what "fairness" in a market situation is - ask a lot of people and you will get an answer that is something like "well, I know it when I see it." If some member of the political constituency is unhappy with prices, then they will often petition government to do something about these prices. One of the main tools available to a government to change the outcome of a market is a price control.

A price control comes in two flavors: a price ceiling, where the government mandates a maximum allowable price for a good, and a price floor, in which the government sets a minimum price, below which the price is not allowed to fall.

Price controls can be thought of as "binding" or "non-binding." A non-binding price control is not really an economic issue, since it does not affect the equilibrium price. If a price ceiling is set at a level that is higher than the market equilibrium, then it will not affect the price. Think of an example: suppose the borough of State College decides that it wants to make sure that no student is denied toothpaste, and decides that it will set a price ceiling of $10 per tube on toothpaste. Well, almost all tubes of toothpaste cost a lot less than that - most are about $3 or $4 per tube. So setting a maximum price that is above the market equilibrium will not really affect the market equilibrium. The same can be said for price floors that are below the equilibrium price. If the state sets a minimum price of $1.00 per gallon on gasoline, it is not going to have any effect at current price levels.

OK, so let's not worry too much about non-binding price controls. Let's restrict our thinking to ones that change the price that consumers see in the market. We'll start by talking about price ceilings, which are sometimes called price caps. Price caps are one way to address issues of market power. In situations where it is felt that the price is artificially high because of a lack of competition, one of the actions a government can take is to set a maximum price a monopolist can charge. Let's look at a couple of examples. One of the most frequently cited example is that of price caps on rental accommodations, the most famous case in the US being that of New York City. As the United States entered World War II in 1942, a crash program of ship-building was started in addition to other munitions and arms manufacturing. One of the places where many ships were built was the Brooklyn Navy Yard. The rapid increase in the demand for labor caused a lot of people to move to New York. These migrants needed places to live and soon filled up all of the available apartments in New York. Given that apartment buildings are capital, and cannot be built overnight in response to increased demand, when they filled up, landlords would be in a position of market power and would be able to charge higher and higher prices when every apartment came on the market or when a lease ended. In order to stop this from happening, as a wartime emergency measure, the City of New York instituted rent controls, setting maximum amounts on what a landlord could charge.

It should be noted that World War II ended in 1945. This was 75 years ago, but rent control persists in New York to this day. As an aside, the Federal Income Tax was originally intended to be an "emergency measure" to help pay for the costs of World War I. That war ended a little over a century ago, but the income tax is still with us. Perhaps this is a hint that we should be careful about granting politicians the power to adopt "emergency measures," as they have a habit of sticking around long after the emergency has ended.

You can imagine what these rent caps did. In a market, high prices serve as a signal to producers that demand has increased, and every businessman lives to find an unsatisfied demand. This is where the lure of positive economic profits lies. High prices act as a magnet to bring more supply to a market, and that extra supply competes with the existing supply to help drive prices down to an equilibrium. High rent prices are a signal, telling prospective builders where their product is most needed. This is what Adam Smith was talking about when he coined the metaphor "the invisible hand," guiding the behavior of consumers and producers.

Rent control removes the economic signal that buildings are in demand in New York. For this reason, providers of apartment houses have no incentive to build new apartments. So, we still have lots of workers flocking to the city, all the apartments are full, and nobody has an incentive to build new ones because the prices are controlled. This does nothing to alleviate the shortage of apartments. It just means that instead of apartments being rationed by price, they are rationed by some other method - maybe "first-come, first-served," but more likely some other method. These other methods are what we know as the "underground economy," which is otherwise referred to as a "black market".

In New York, rent control gave rise to a variety of practices, all of which were against the official rules. One was the practice of sub-letting. Say that you are lucky enough to have a rent-controlled (that is, cheap) apartment in Manhattan. You get married and start a family, and you decide you want to move out to the suburbs. Normally, a person in this situation would give up his apartment and buy a house in the burbs. However, it is profitable to officially keep your name on the lease, and instead allow somebody else to live in the apartment. Since apartments are scarce, people are willing to pay more than the market price. So maybe you can keep the lease, charge somebody $2,000 to let them live in the building, and pay the landlord the rent-controlled rate, which might be $600 per month. You have a big incentive to keep your name on the lease. Another practice is "key money," in which case landlords take "under-the-table" payments upfront to allow a person to move into a rent-controlled apartment. There are some other side-effects as well: because landlords can raise the price (by a small amount) when somebody vacates the apartment, they have an incentive to have people move in and out as often as possible, and they have no incentive to spend a lot of money on maintenance, as they are not interested in keeping tenants happy - a rather dysfunctional outcome that should never exist in an uncontrolled market.

Another side effect is that we still have a shortage of housing, and whenever there is a shortage, government gets called on to fix the problem. In this case, the City of New York built a lot of apartment buildings, which were commonly known as "housing projects" and quickly developed a reputation as being very unpleasant places to live. So, one government policy designed to alleviate market power led to lots of illegal and inefficient practices, lots of unhappy tenants, and the entry of the government into the housing market in a big way. It is fair to say that this is a case where a government trying to fix a problem has ended up making things a lot worse. Rent control is almost gone in New York, but has proved to be very difficult to phase out.

Anti-gouging rules are another example. In cases like this, sellers are barred from raising prices above some level that is thought to be "reasonable" in unusual circumstances that would normally allow them to raise prices. This topic often arises in the aftermath of natural disasters. Let's say, for example, that bridges to the Outer Banks of North Carolina get wiped out by a hurricane, and it is temporarily impossible to truck supplies to the islands. At the same time, power is out, so water cannot be pumped to homes. In this situation, there would be a large outward movement of the demand curve for water. At the same time, the replacement cost of the water (that is, the marginal cost of the replacement unit) would be very high, moving the supply curve up. Both of these effects should cause the price to increase significantly. When this happens, it is often decried as "greed" in the face of tragedy. In reality, raising the price of bottled water is the signal that tells other firms to do whatever they can to get water to the islands. If the price of a bottle goes up to $10 or $20, then some other supplier would hire helicopters or boats to make sure that they could sell water on the island. If the price is capped at, say $3 per bottle due to anti-gouging rules, then no other company has an incentive to move water to the islands and the shortage persists longer than it otherwise would. Another example: in North Carolina, anti-gouging laws cap the price rises of gasoline when the governor activates the laws. After Hurricane Ike hit the refining belt in Southern Texas in 2008, there was an acute shortage of gasoline in the south. Several gas stations were fined for raising their prices too quickly, from $2.50 to over $4. Oddly enough, one station near the Orlando International Airport that always priced its gas at over $4 per gallon, due to proximity to car rental lots, was not fined, even though their price was as high as the "gouger" stations.

Let’s look at a supply/demand diagram with a price cap.

In this diagram, we have a price cap, PC, which is a horizontal line below the equilibrium price, P*. The quantity demanded, Q(d), is the amount at which the price cap and the demand curve intersect. The quantity supplied, Q(s), is where the price cap and the supply curve intersect. From the diagram, you can see that Q(d) is greater than Q(s). That is, we have more people who want to buy than we have people who are willing to sell. This should be obvious – if the price is lowered, more people will want to buy.

So, in this market, the supply is unable to meet the demand. So there is a “Shortage” of the good in question. Only some of the demanders get to buy, but they do get to pay a lower price. We have a new equilibrium, which is defined by (PC, Q(s)), which is at a lower price and quantity than the free-market equilibrium, (P*, Q*)

What about the consumer and producer surpluses?

We know that the producer surplus is the area between the equilibrium price and the supply curve. In the above diagram, this is the red area. Obviously, this will be smaller than in the free market. The consumer surplus is the area between the demand curve and the equilibrium price, which is the blue area in the above diagram. We do not know, without numbers, if this is larger than the free-market consumer surplus. But we do see that some wealth has been transferred from the producers to the consumers (or so it seems – more on this later.)

The green area represents the buyers and sellers who would be able to trade in a free market but are unable to in the controlled market. Because they cannot trade, they gain zero wealth from this market instead of some wealth. So, the green area is wealth from trade that is lost to society. This area is called the Deadweight Loss. It is a loss in wealth caused by a price control.

Now, think about the “shortage”. We have more buyers than sellers. Usually, the buyers will compete with each other by offering more money. But they are not allowed to do that here. But they will compete in other ways. They will wait in line longer. They will get out of bed earlier and show up at the shop earlier. They will buy from people on the black market. The people who want the goods the most will compete until they have the goods.

They will use up resources (time, energy, money) in this competition, but those resources will not go to the seller. Instead, they are lost to society. If we look at the following diagram, we will see that the buyers will compete until the price has been driven up to the level called “PR”, the “Real Price.” Only people willing to pay more than PC will end up with the goods. The most they are allowed to pay in cash is PC, but they spend PR. The area between PC and PR is called the “hidden costs” – hidden because they are not observed in the official transaction. They are the costs of competing for the goods and are lost to society.

So the “hidden cost” is the yellow part of this diagram. The green is the deadweight loss, and the consumer and producer surpluses are shown in blue and red. As we can see, the “real” wealth, the producer and consumer surpluses, are much smaller than they would be in a free market.

You will also notice that the “Real Price,” PR, is higher than the equilibrium price, P*. The original goal was to lower the price, but we have ended up raising the price. Trying to help consumers by lowering the price has actually raised the price.

Example

Suppose supply and demand functions in a market are given as:

P S = 3 Q S + 30 P D = 350 − 5 Q D

Find the completive market equilibrium price, quantity, consumer surplus, producer surplus, and total wealth.

3 Q + 30 = 350 − 5 Q 8 Q = 320 Q * = 320 / 8 = 40 P * = 3 * 40 + 30 = 150 C S = ( 350 − 150 ) * 40 / 2 = 4000 P S = ( 150 − 30 ) * 40 / 2 = 2400 T W = C S + P S = 4000 + 2400 = 6400

Determine the impact of the price ceiling P C = 120

Q s is extracted from supply function by setting the price as P C = 120 :

P S = 3 Q S + 30 120 = 3 Q S + 30 90 = 3 Q S Q S = 90 / 3 = 30

And Q D can be found from demand function by setting the price as P C = 120 :

P D = 350 − 5 Q D 120 = 350 − 5 Q D 350 − 120 = 5 Q D Q D = 230 / 5 = 46

As we can see supply quantity, Q S , is less than the competitive market equilibrium, while the demand quantity, Q D is higher.

And Real Price, PR, can be found by plugging the Q S into the demand function: P R = 350 − 5 * 30 = 200

In order to find the consumer surplus, we need to calculate the area of the blue trapezoid. Please note that P R is the top right corner of the trapezoid.

C S = [ ( 350 − 120 ) + ( 200 − 120 ) ] * 30 / 2 = 4650

P S = ( 120 − 30 ) * 30 / 2 = 1350 T W = C S + P S = 4650 + 1350 = 6000

And finally, Deadweight Loss can be found in two ways:
Calculating the area of the green triangle:


How gas price controls sparked ྂs shortages

Proposals to control gasoline prices and tax producers’ windfall profits were popular ideas that were tried — without much success — during the oil shocks of the 1970s and 1980s.

The era of price controls is most remembered for long lines at gas stations. The controls were put in place by the Nixon and Ford administrations in reaction to a jump in fuel prices caused by cuts in production by the newly formed international oil cartel, the Organization of Petroleum Exporting Countries.

Back then, “price controls turned a minor adjustment into a major shortage,” said Thomas Sowell, author of “Basic Economics: A Citizen’s Guide to the Economy.”

Mr. Sowell says that although the best response would have been to let prices rise, giving oil companies an incentive to produce more and consumers an incentive to conserve, “this basic level of economics is seldom understood by the public, which often demands ‘political’ solutions that turn out to make matters worse.”

The public — as it does today — wanted low prices. But the artificially depressed pump prices imposed during the oil crisis of 1973 — which stayed in place in various iterations through 1980 — brought about lines at gas stations and an artificial shortage of gas, he said.

The price controls resulted in a fuel-rationing system that made available about 5 percent less oil than was consumed before the controls. Consumers scrambled and sat in lines to ensure they weren’t left without. Gas stations found they only had to stay open a few hours a day to empty out their tanks. Because they could not raise prices, they closed down after selling out their gas to hold down their labor and operating costs, Mr. Sowell said.

The shutdown of stations that had been open at all hours before price controls further raised the public’s panic level and resulted in more lines, anger and frustration in what many Americans still remember as one of the nation’s worst economic nightmares.

“No doubt many or most motorists whose daily lives and work were disrupted by having to spend hours waiting in line behind other cars at filling stations would gladly have paid a few cents more per gallon to avoid such inconveniences and stress,” Mr. Sowell said.

Those who preferred not to sit in line bought gas on the black market at exorbitant prices far above what the market price would have been, he said. “Price controls almost invariably lead to black markets.”

By the Iranian oil crisis in 1979, the controls had grown unsustainable as oil prices escalated in global markets. With lines forming once again and fistfights breaking out at the pump, President Carter quickly waived most of the controls on oil and gas prices to make more fuel available.

The resulting sharp price increases ushered in a new nightmare: double-digit inflation, as businesses quickly passed on their higher fuel costs and workers’ unions demanded cost- of-living increases to keep pace with higher prices. The surge in inflation put the Federal Reserve in crisis mode. It ordered its largest-ever increase in interest rates in October 1979, plunging the economy into a deep recession.

By the 1980s, Congress and the administration had figured out that price controls were not the answer.

President Reagan, who rode to office on anger over the recurrent energy crises and inflation of the previous decade, immediately abolished what remained of oil and gas price controls upon entering office in 1981.

Harvard University economist Joseph Kalt concluded that the 1970s price controls had saved consumers between $5 billion and $12 billion a year in gas costs, but at the price of stifling domestic oil production and causing an artificial shortage of as much as 1.4 million barrels a day.

By 1986, the deregulation of the petroleum industry led to record production levels and a glut of oil that drove prices down to $10 a barrel. The trend toward low prices and plentiful oil continued through the 1990s as major non-OPEC producers such as Russia ratcheted up output to take advantage of the high oil prices engineered by the cartel.

But the eradication of price controls came with a hitch: Congress enacted a new system of “windfall profits taxes” on oil companies in 1980 in an effort to ensure they did not profit egregiously from their newfound freedom to charge market prices.

The tax on the “windfall” revenues earned by U.S. oil companies when market prices were substantially higher than their cost of extracting oil turned out to be another bomb, said Jerry Taylor, analyst with the Cato Institute.

Increased production around the world drove down the price of oil and caused the tax to generate less revenue than expected. By the time it expired in 1988, the tax had generated $40 billion in revenue instead of the $175 billion estimated by the Treasury. After oil prices collapsed in 1986, the tax produced no revenue at all.

Because the tax was applied to U.S. oil producers but not international companies, the Congressional Research Service concluded that it had cut domestic production by 3 percent to 6 percent and increased oil imports by 8 percent to 16 percent.

The tax was “counterproductive,” said Mr. Taylor. It “discouraged investment in the oil business.”

Mr. Sowell said profits are the least-understood aspect of business, and have been under attack since the days of Karl Marx and George Bernard Shaw, who called profits arbitrary “overcharges” motivated by greed.

In reality, profits provide the vital incentive businesses need to make products consumers want at low prices, he said.

Most businesses that succeed do so because they find a way to mass-produce items that the public wants at low prices, he said, noting the examples of Henry Ford’s automobile empire and Wal-Mart’s international chain of discount stores.

In the past century, Mr. Sowell noted, socialist economies were viewed as virtuous because they operated without profits, yet they were never as good as capitalism at generating goods and services people wanted because of the bureaucratic inefficiencies of state-run economies.

Pete Geddes, executive vice president of the Foundation for Research on Economics and the Environment, noted that discredited proposals such as price controls and windfall profits taxes seem to come up every time gas prices get uncomfortably high.

“What is it about rising gasoline prices that causes IQs and body temperatures to converge?” he asked, calling the windfall profits tax “a transparently absurd act of political pandering.”


Effects of Price Control by Government

Government may find it wise to prevent rise in prices above the market equilibrium or to prevent fall in prices below the market equilibrium. Such method of intervention is called price control.

Sometimes businessmen create an artificial scarcity of an essential commodity with the motive of raising the price of the commodity. The basic motive is, of course, profit-maximization. In the process, consumers are exploited since they are now forced to purchase commodity at a higher price.

In order to protect the interest of the consumers the government imposes price ceiling or maximum price above which no one will sell the commodity. This is called ‘price ceiling’ or ‘maximum price legislation’.

Again, prices of commodities may tumble if there are surplus productions. This happens mainly in the case of agricultural commodities when there is a bumper production. “Too low” prices of such agricultural commodities cause hardship to farmers. To prevent prices from falling further, the government may adopt “minimum price legislation” to protect the interests of farmers or producers,

The effect of maximum price legislation can be explained in terms of Fig. 4.28 where the DD and SS curves cut each other at point E. Equilibrium price thus obtained is OP and the equilibrium quantity is OQ. Let us suppose that the government thinks that this OP price is “too high”. So, it fixes a maximum price at OPmax, below the equilibrium price (OPmax < OP).

At this lower price, consumers demand a larger quantity OQ2 but producers cut back their supplies to OQ1. The immediate effect of this price ceiling is, thus, the emergence of excess demand or persistent shortage of the commodity. Because of the legal stipulation of price, neither buyers nor sellers dare enough to raise the price to eliminate excess demand. So, excess demand in the market would stay.

Though maximum price legislation is made by the government to improve the welfare of the people, some people, in the process, gain, while some lose. Producers may lose as they are supposed to accept lower prices. T

his may force some producers not to produce the commodity. Further, some consumers lose, but not all some consumers who can purchase the good at a lower price stand to gain, but those who have been ‘rationed out’ and cannot afford to buy the good at all stand to lose.

Now, sellers would devise various policies to allocate OQ1 among the buyers. Firstly, sellers may adopt a democratic principle of distribution i.e., the principle of ‘first-come, first-served’. Secondly, sellers may hoard it ‘under the counter’ and distribute it only to the favoured customers or friends. Naturally, these allocational principles would certainly put some of the buyers in a disadvantageous position.

The first method may lead to formation of long queues in front of the shop thereby creating the possibility of disturbance in the locality. Though democratic, it is not necessarily fair. The second method is equally unacceptable to some buyers, particularly those who do not have any links with the sellers.

Eventually, the existence of unsatisfied demand will create a situation of ‘black marketing’. A situation of black market is one in which sellers sell the goods above the legal minimum price stipulated by the government. Here, to meet unsatisfied demand black marketers charge higher prices than the legal maximum price.

How much price will rise in the black market depends on the intensity of demand. Buyers are ready to buy the limited quantities, i.e., OQ1 at the price OM. Thus OM is the price charged in the black market. In the process, black marketers stand to gain since legal maximum price is much below the black market price. For OQ1 amount of goods, buyers are willing to pay OMNQ1 amount.

Of this, Pm TNM would be received by the black market price. For OQ1 amount of good buyers are willing to pay OMNQ1 amount. Of this, Pmax TMN would be received by the black marketers as illegal receipts. Since not all buyers can afford to pay such high illegal price, part of the limited quantities would be supplied at controlled price and the rest at illegal price.

Thus, black marketing emerges against the backdrop of limited supplies. In an attempt to allocate limited quantities, the government may find it wise to adopt a system of rationing. Under rationing, the government restricts consumption by assigning a quota to each and every individual so that available goods can be distributed equally.

By giving ration coupons to each and every individual, government may allocate available goods among people equitably. Thus, rationing may be justified during war or emergency when scarcity of a particular commodity or commodities hits the economy. In other words, rationing may be introduced whenever there is a shortage of essential commodities.

Though this method cannot meet all the demands, price control with rationing may yield good result in this direction. So, price control and rationing are complementary to each other. These two can ensure stability in prices. Truly speaking, to make the price control an effective instrument, a system of rationing should be introduced.

Note that rationing is often resorted to under exceptional cases. In normal times, rationing is unjustified. Again, price control with or without rationing is likely to give rise to a black market. Further, administrative inefficiency may creep in the offices of rationing department. This may reduce the effectiveness of price control cum rationing mechanism.

Price Control: The Minimum Price Legislation:

The government often passes law to fix the minimum price or floor price at which commodities may be sold. This minimum price legislation is introduced by the government to protect the interests of producers, mainly agriculturists.

Whenever there is a crash in prices, say of wheat, due to bumper production, the government issues circular that no one would be allowed to sell wheat below the stipulated price. Such is called the minimum price. Certainly, the legal floor price fixed by the government is kept above the equilibrium price determined by the demand and supply curves.

The effect of floor price has been shown in Fig. 4.29. OP is the equilibrium price determined by the intersection of DD and SS curves. Suppose, price crashes below OP— thereby causing great hardships to producers. To woo the producers, the government fixes the minimum price at OPmin below which no one will be allowed to sell.

At this price, there occurs an ‘excess supply’ or persistent surplus measured by the distance AB (= Q1Q2). Because of excess supply the possibility of black marketing does not arise. But some producers may try to sell their stocks of unsold goods at a price below OP1, of course, in a clandestine manner.

We have just shown that, at the price OPmin, there occurs an excess supply of Q 1Q2. The government, in order to safeguard the interests of producers, may purchase all the quantities at the price OPmin. This will result in an increase in governmental expenditure to the tune of Q1Q2BA. This is called ‘subsidy to the producers.

In view of all these, champions of perfectly competitive market argue that the government intervention in normal market mechanism may bring dangers in the economy, particularly if such intervention is based on pure discretion rather than on any socio-economic consideration. Above all, maximum or minimum price legislation may bring disaster if government machinery becomes inefficient.


Tejvan Pettinger studied PPE at LMH, Oxford University. Find out more

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Price Controls Are Not The Answer To Expensive Drugs

The isolated measures of price fixing fail to attain the ends sought. In fact, they produce effects contrary to those aimed at by the government. If the government, in order to eliminate these inexorable and unwelcome consequences, pursues its course further and further, it finally transforms the system of capitalism and free enterprise into socialism.

Ludwig von Mises

Despite their abysmal track record, government solutions are back in vogue. Ostensibly, government’s scale, leverage, and freedom from profit will unlock potential health care savings that are beyond the reach of the private sector.

At their most extreme, reforms such as “Medicare for all” call for a complete government takeover of the health care system. Proponents of single payer reforms claim that only a complete government takeover of the health care sector can eliminate the health care sector’s inefficiencies and ensure 100 percent patient coverage.

Of course, if government’s scale and freedom from having to earn a profit was so effective, then why does FedEx and UPS consistently outperform the U.S. Postal Service? Or, why is Amtrak always teetering on the brink of insolvency? In the health care space, if scale and the freedom from having to pay a profit is so important, why is the health care provided by the Veteran’s Administration and the Indian Health Service so abysmal?

Heightening these concerns, 80 percent of primary care doctors will accept new patients that are covered by private insurance, but only 72 percent will accept new Medicare patients and 45 percent new Medicaid patients. This lower acceptance rate is linked to Medicare’s and Medicaid’s uneconomical reimbursement levels. And, herein lies the rub.

Whether it is state Medicaid programs, the federal Veteran Affairs health system, or nationalized health systems in other countries, government-run health care creates savings by restricting access and reducing the quality of care. It is folly to believe that government will be able to provide high quality health care services at a reasonable cost.

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Others preach that, instead of a complete government takeover of the health care system, the best way to lower the cost of health care is through increased government regulations. These piecemeal proposals will identify a specific problem that plagues the health care system, and then offer targeted government programs to address each one.

Take the cost of medicine. In response to the high cost of branded and originator biologic medicines, there has been a bipartisan push to impose price controls on drugs. Here too, history argues that the big-government approach will disappoint its proponents.

In post-revolution France, for instance, the government imposed grain price controls to ease the pain from the grain shortages that were plaguing the country. The price controls not only failed to alleviate the problem, they worsened the shortages and helped create an even greater economic crisis.

Rent control policies also exemplify the adverse consequences from government mandated pricing. The purpose of rent control is to expand the availability of affordable housing. The actual consequences, as exemplified by cities like New York and San Francisco, are housing shortages and sharp declines in housing quality.

No matter where they have been tried, price controls have always made bad situations worse because it is impossible for policymakers to have the necessary knowledge to dynamically set the efficient price level. Just as all of these past price control experiments ended up making a bad situation worse, applying price controls to the U.S. health care sector will further reduce the quality of care and create inequitable outcomes.

The advocates of price controls now are targeting the pharmaceutical industry with these ill-considered policies. Take H.R. 3, the Lower Drug Costs Now Act. As the name implies, the bill’s proponents hope to lower the cost of drugs by empowering the Centers for Medicare & Medicaid Services (CMS) to negotiate prices on certain drugs. Manufacturers who refused to negotiate with the government would face a 95% tax on sales revenue (not profits). Such a lopsided structure is not a negotiation, it is the government mandating a price regardless of its economic viability.

The consequences from implementing price controls on the pharmaceutical industry will be no different than the consequences that occurred in the grain or housing markets. But, one does not even have to look toward these markets to see the consequences. Just look to the European Union’s drug industry, where pharmaceutical price controls were implemented two decades ago.

Before its price controls, EU firms were the global leaders in biopharmaceutical innovation. Since the implementation of price controls, research spending in the EU has stagnated, much of it diverting to the U.S. where price controls do not exist. Over time, these diverging trends have enabled the U.S. to become the global innovation leader.

As a result, the EU has endured many adverse consequences. Access to existing medicines have faltered. While the U.S. has access to nearly 90% of newly launched medicines, patients in Germany only have access to 71%. In France, the access rate is even lower at 48%.

By some estimates, the R&D slowdown has led to 46 fewer medicines being introduced into the marketplace. The actual costs to patients (worldwide) from not having access to new (possibly better) treatments is unknowable. The lost savings potential these medicines could have created, by avoiding the need for other more expensive health care treatments (e.g. surgeries), is also unknowable. The EU has also faced economic consequences as the lost R&D activity has cost the EU nearly 1,700 high paying research jobs.

History clearly illustrates that government mandated prices create more harm than good. Should drug price controls, such as H.R. 3, be implemented, the U.S. will not be exempt from the adverse consequences. Instead, access will be reduced, innovation will suffer, and the economy will be less vibrant.

In contrast to this government approach, as I have discussed here, there is a better way. Too many market barriers currently exist that are inhibiting a more competitive market for medicines (particularly the high-cost biologic medicines) to develop. The best way to achieve the dual goals of incenting innovation and promoting affordability is to remove these barriers and empower a competitive market to directly lower the costs of medicines.

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