Saturday, April 14, 2012

Natural gas price controls

« True, false, uncertain: "Natural gas price controls during the late 1970s hurt producers at the expense of consumers, but did improve economic efficiency." ». Here is my answer to that question (this question is discussed in an interesting post « How to answer “true, false, uncertain” questions » by Frances Woolley).

Price controls drive the price lower than it would be without it. Everything else remaining the same, it is a transfer from the producers to the consumers. But everything else does not remain the same.

Since the price is lower, producers will try to reduce their costs. A typical way to reduce costs is to reduce production since it typically costs more to produce the last unit than a preceding unit. Firms whose costs are too high may also go out of business, thus reducing global production. Insofar as this applies to natural gas production in the late 70’s (natural gas is a quite special product: not only because of high fixed costs, but also because it is a non-renewable resource), lower prices reduce production by eliminating production that is not profitable. However, if there is a monopoly or if the producers agree among themselves to limit production in order to increase prices, imposing lowering the price through price controls could even increase production: producers will take the controlled price as a given and produce as much as is profitable at that price since they cannot increase the price by restricting production.

The producers are unambiguously hurt by the price controls since the price is lower. Sure, they can mitigate this effect by changing production. But if they preferred to produce that amount at that price, they could have done it before the price controls. Since they haven’t done it, this means that they prefer their previous position and are hurt by price controls.

Benefiting from a lower price was not an option for consumers before price controls. Thus, it cannot be excluded that the consumers benefit from the controls. In fact, consumers lose from these controls only if there is a reduction of production that is so large that the inconvenience of gas shortages more than offsets the gain of paying less for each unit.

If everybody is worse off, we can conclude that price controls reduce economic efficiency. We said that producers are unambiguously hurt by price controls. Thus if consumers benefit from them, we are already in a situation where interests diverge. But let’s assume that the price controls lead to a reduction in production that is large enough for the consumers to be hurt too. At first sight it thus seems that in this case the price controls would be inefficient. But we must make sure to include all impacts on everybody. What about future generations? If less gas is produced today, that leaves more gas for future generations. Thus price controls may be good for future generations. Thus, in this case also, interests may diverge. We cannot assess efficiency without taking a stand on the relative value of the various interests.

The usual stand taken in economics is that a pure transfer does not change global well-being (“pure” in the sense that we have separately taken account of secondary effects like a change in the quantities produced): it doesn’t matter who gets what. Let’s assume first that, in the absence of price control, the price would be such that all gas is produced whose cost is less than its usefulness. Then, introducing price controls will reduce efficiency if the quantity produced changes. Indeed, the consumers’ gain from a lower price on the gas they buy is exactly offset by the producers’ loss on what they sell.  But both consumers and producers lose from reduced production: some gas whose usefulness is greater than its cost is not produced (the benefit could have been shared between consumers and producers). This decreases economic efficiency. However, one has to check that the situation without price controls was efficient (or check that, even if the situation without price controls was not efficient, price controls at the level existing in the late 70’s made matters worse). There are various reasons why the situation without price controls may not be efficient. As discussed previously, competition may for example be imperfect, allowing producers to restrict production in order to increase the price. In this case, price controls may lead to an efficient increase of production (this, however, is not the case if the controlled price is low enough): leading to the production of gas that would not have been produced without price controls although its usefulness is greater than its cost. Another reason involves other sectors than the natural gas market. If for example there is too much unemployment because of an excess demand for money (people and firms want to hold money), then a transfer from producers to consumers may actually help the economy if consumers are more inclined to consume than producers.
Now you can refuse to take the stand that a pure transfer does not change global well-being. You may have more sympathy for one group or another. Maybe some natural gas is imported, and you do not care about the well-being of those foreign producers. Maybe you consider than 1$ in an almost empty pocket will produce more well-being than the same dollar in an already full pocket. Whatever your reason, if you refuse to take the stand that a pure transfer does not change global well-being, you will have to take another stand, and your conclusions may depend on that stand. Even if you conclude that price controls improve economic efficiency in the sense that they increase global well-being as you define it, you may ask yourself if there is another policy that would yield the same result at lower cost, and thus be even better.

Is it true that natural gas price controls during the late 1970s hurt producers at the expense of consumers, but did improve economic efficiency? Sheer logic cannot answer that question. The answer depends on the stand taken as to the weights attributed to the relative worth of the well-being of various individuals. Even if we agree on one stand (for example the usual stand that pure transfer does not change global well-being), then we still need factual information about the natural gas market in the late 70’s. For example, would the situation in the absence of price controls have been inefficient because of imperfect competition, pollution, impact on future generations or for some other reasons? When these are taken into account, the net result depends (in addition to the stand) on the intensity of the various effects (which cannot be assessed without further data).

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