Effects of Government Intervention Price Controls

In the United States and most other industrial countries, markets are rarely free of government intervention. Besides imposing taxes and granting subsidies, governments often regulate markets (even competitive markets) in a variety of ways. Here we will see how to use supply and demand curves to analyze the effects of one common form of government intervention: price controls. Later, in Chapter 9, we examine the effects of price controls and other forms of government intervention and regulation in more detail.

Figure 2.20 illustrates the effects of price controls. Here Po and Qo are the equilibrium price and quantity that would prevail without government regulation. The government, however, has decided that Po is too high and has mandated that the price can be no higher than a maximum allowable ceiling price, denoted by Pmax. What is the result? At this lower price, producers (particularly those with higher costs) will produce less, and supply will be Qi. Consumers, on the other hand, will demand more at this low price; they would like to purchase the quantity Qi. So demand exceeds supply, and a shortage develops, known as excess demand. The amount of excess demand is Qi - Qu

This excess demand sometimes takes the form of queues, as when drivers lined up to buy gasoline during the winter of 1974 and the summer of 1979. (In both instances, the gasoline lines were the result of price controls; the government prevented domestic oil and gasoline prices from rising along with world oil prices.) Sometimes it takes the form of curtailments and supply rationing, as with natural gas price controls and the resulting gas shortages of the mid-1970s, when industrial consumers of gas had their supplies cut off, forcing factories to close. And sometimes it spills over to other markets, where it artificially increases demand. For example, natural gas price controls caused potential buyers of gas to use oil instead.

Some people gain and some lose from price controls. As Figure 2.20 suggests, producers lose-they receive lower prices, and some leave the industry. Some but not all consumers gain. Consumers who can purchase the good at a lower price are clearly better off, but .those who have been "rationed out" and cannot buy the good at all are worse off. How large are the gains to the winners, how large are the losses to the losers, and do the total gains exceed the total losses? To answer these questions we need a method to measure the

Qi Qo Qi Quantity

figure 2.20 Effects of Price Ctontols^Wjt^ taaxket clears at the equilibrium price and quantity P0'anc( Q0. Ifjppbe is regtflaVH'^be no higher than P^ supply falls to Q,_, demand increases tp^¿j^nd.¿'shortage develops," 1 '

gains and losses from price controls and other forms of government intervention. We discuss such a method in Chapter 9.

In 1954, the federal government began regulating the wellhead price of natural gas. Initially the controls were not binding; the ceiling prices were above those that cleared the market. But in about 1962, these ceiling prices did become binding, and excess demand for natural gas developed and slowly began to grow. In the 1970s, this excess demand, spurred by higher oil prices, became severe and led to widespread curtailments. Ceiling prices were far below those that would have prevailed in a free market.12

This regulation began with the Supreme Court's 1954 decision requiring the then Federal Power Commission to regulate wellhead prices on natural gas sold to interstate pipeline companies. These price controls were largely removed during the 1980s, under the mandate of the Natural Gas Policy Actofl978.Foradetaileddiscussionofnaturalgasregulationanditseffects,seePaulW.MacAvoy and Robert S. Pindyck, The Economics of the Natural Gas Shortage (Amsterdam: North-Holland, 1975) R. S. Pindyck, "Higher Energy Prices and the Supply of Natural Gas," Energy Systems and Policy 2 (1978): 177-209, and Arlon R. Tussing and Connie C. Barlow, The Natural Gas Industry (Cambridge Mass.: Ballinger, 1984).

To analyze the impact of these price controls, we will take 1975 as a case in point. Based on econometric studies of natural gas markets and the behavior of those markets as controls were gradually lifted during the 1980s, the following data describe the market in 1975. The free market price of natural gas would have been about $2.00 per mcf (Lhousand cubic feet), and production and consumption would have been about 20. Tcf (trillion cubic feet). The average price of oil (including both imports and domestic production), which affects both supply and demand for natural gas, was about $8/barrel.

A reasonable estimate for the price elasticity of supply is 0.2. Higher oil prices also lead to more natural gas production because oil and gas are often discovered and produced together; an estimate of the cross-price elasticity of supply is 0.1. As for demand, the price elasticity is about -0.5, and the cross-price elasticity with respect to oil price is about 15. You can verify that the following linear supply and demand curves fit these numbers:

Demand: Q = -5Pg + 3.75Po where Q is the quantity of natural gas (in Tcf), Pg is the price of natural gas (in dollars per mcf), and Po is the price of oil (in dollars per barrel). You can also verify, by equating supply and demand and substituting $8.00 for Po, that these supply and demand curves imply an equilibrium free market price of $2.00 for natural gas.

The regulated price of gas in 1975 was about $1.00 per mcf. Substituting this price for Pg in the supply function gives a quantity supplied (Qi in Figure 2.20) of 18 Tcf. Substituting for Pg in the demand function gives a demand (Qi in Figure 2.20) of 25 Tcf. Price controls thus created an excess demand of 25 -18 = 7 Tcf, which manifested itself in the form of widespread curtailments.

Price regulation was a major component of U.S. energy policy during the 1960s and 1970s, and it continued to influence the evolution of natural gas markets in the 1980s. In Example 9.1 of Chapter 9, we show how to measure the gains and losses that result from natural gas price controls.

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