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How To Create A Shortage

August 29, 2005

People are not happy about this latest round of gas price increases; and, not surprisingly, they are demanding answers — and "solutions" — from the wrong people: the political classes. At the cutting edge is Hawaii, where gas prices will soon be controlled by law, not markets.

Hawaiians are about to find out in the near future that the "solutions" they have supported are going to have the opposite effect of what supposedly was intended.

People in the Aloha State pay more for gasoline than anyone else in the United States, and anyone with even a basic understanding of economics understands why this is so. Hawaii is a group of islands located thousands of miles from the continental US, and Hawaiians who purchase gasoline must be willing also to pay for the high transportation costs of bringing fuel to that state. (At more than 57 cents a gallon, Hawaiians also pay the highest gasoline taxes in the USA, a penny more than their California counterparts and about 13 cents more than the national average, according to the American Petroleum Institute.)

Hawaiians believe this to be a most unfair set of circumstances and have turned to their legislature for what they believe to be relief. Yes, even though the high prices that people in Hawaii pay for gasoline are due to that pesky thing called the Law of Scarcity, citizens of that state are convinced that the politicians there can do away with scarcity by fiat. They are about to discover just how wrong they really are.

According to John W. Schoen of MSNBC:

... Hawaiian motorists, who pay the highest prices in the U.S., may get some relief as the state becomes the first in the nation to put a price cap on gasoline. The new law, which takes effect Sept. 1, allows the state Public Utilities Commission to set a maximum wholesale price for gasoline in Hawaii, based on the weekly average of spot prices in Los Angeles, New York and the U.S. Gulf Coast. The law would not put a cap on retail prices.

To a politician or a journalist, this would seem to be a reasonable scheme. By holding down the wholesale price of gasoline, the government of Hawaii is "lowering the costs" that retailers will have to pay for fuel, thus enabling them to "pass on" the savings to their customers. Yet, the whole program is based upon a fallacy of economics — one that has haunted economics for centuries — and even though economists have debunked this fallacy for more than 130 years, it still lives on. The fallacy is this: the price of a final (consumer) good is determined by its cost of production.

Adam Smith and the so-called Classical School economists of 19th-century Great Britain were stymied in their economic analysis because they held to this fallacy. While a number of individuals on the European continent were able to see through this quandary, the problem was not solved until the 1871 publication of Carl Menger's Principles of Economics.[1]

Menger not only "solved" the so-called Diamond-Water Paradox that had befuddled economists, but he also made a major contribution to economic thought by correctly identifying the source of value for what he called "higher-order" goods, or capital goods. (Higher-order goods also are intermediate goods that are in an "unfinished state," such as a log before it becomes lumber or crude oil before it is refined into goods such as gasoline, nylon, and other fuels.)

In Mengarian language, wholesale gasoline would be a higher-order good. Crude oil also would be a higher-order good, not to mention all of the various factors of production that are involved in the production and transportation of oil and oil-derived products. The value for those higher-order goods is determined by the value that consumers place upon the final products, such as gasoline, heating oil, and other oil-derived goods, such as nylon sportswear.

What does Mengarian (actually, Austrian) value theory have to do with the current price of gasoline in Hawaii (or anyplace else)? It tells us that the value of wholesale gasoline is determined by the value of what people are willing to pay at the pump, not the other way around.

The confusion on this issue does not simply rest with the government of Hawaii. A visit to the website of the American Petroleum Institute produces the same fallacious information as what Hawaiian legislators were discussing. In answer to the question of higher gasoline prices, the API site tells us that these price increases are due to the "higher cost of crude oil." Thus, in this kind of parlance, the higher costs are "passed on" to consumers because of alleged "monopoly power" of the oil producers.

Yet, what really is occurring and why? The standard answers include U.S. demand, political instability in the Middle East, and increased demand from Asia. All of this is true, in one sense. For example, the political atmosphere surrounding the U.S. occupation of Iraq certainly is going to affect the oil supplies in that region, and creates grave uncertainties about future supplies. Oil traders, who want to be assured of having a consistent supply of oil in the future are willing to pay higher prices now as insurance.

(Another reason crude oil prices are rising [and this is only a sidebar, as this point deserves a whole other article] is that oil is a commodity, and commodity prices often are bid up when dominant currencies [like the dollar] are being inflated. People with dollars are looking for investments with a good return, and oil happens to be one of them right now.)

However — and this is a very big however — the only reason that traders are willing to pay those prices for crude oil is because they believe that individuals are willing to purchase fuels refined from crude at prices that will enable those original purchases to be profitable. In fact, the price of crude oil cannot rise independently of the value of the final products into which it is refined. Even though we are seeing a pattern in which the price of crude oil increases, which is followed by increases in retail gasoline prices, one must be reminded of the economic processes that are occurring.

For example, when President Jimmy Carter announced in 1980 that his administration was beginning a phased decontrol of oil prices, leftist groups such as the Citizen/Labor Energy Coalition predicted that by 1990, crude oil prices would rise to nearly $600 a barrel, a prediction repeated by a straight-faced mainstream news media. (Before Iraq's invasion of Kuwait in the summer of 1990, oil prices stood at about $18 a barrel, so the "energy experts" were off by only $582.)

All of this brings us back to Hawaii's pricing scheme, but one must keep something in mind. This was pretty much the same policy that the U.S. government followed back in the 1970s when it controlled prices at domestic wellheads, and at the pump. Any reader who was driving a car during that decade can remember the chaos that incurred, especially whenever there was turmoil overseas.

The government's logic went like this: if we keep the price at the wellhead low, then the savings will be passed on to consumers. However, by placing price controls on crude oil, the government managed to do two things. First, it created shortages of crude oil, as producers saw no incentive to take many risks to drill for more oil. (Yes, the government claimed it had "incentives" built into its policies, but these were the usual byzantine sets of bureaucratic incentives that had no basis in economic reality.) Second, it drove producers to purchase the more available crude oil that was made available from the Middle East. For all of the talk of "dependence" upon "foreign oil," government policies were the driving force in encouraging oil companies to look overseas for supplies of crude.

Policies guiding the pump price were just as bad. Using the logic of "Classical" economics, the government figured that if it took about a month for crude oil after it was pumped from the ground actually to find its way into a vehicle, then pump prices could not increase until a month or so after crude prices went up. Thus, consumers, anticipating price increases, went on "buy now" binges, which quickly used up existing supplies, causing gas lines and the infamous "out of gas" signs that littered gas stations.

Like the federal government's disastrous central planning of 30 years ago, the Hawaiian government has attempted to build in some alleged market mechanisms into its scheme. As noted earlier, wholesalers will be permitted to charge administered "prices" based upon average prices elsewhere. Of course, with this scheme, prices no longer serve their function, but are just data points. Any adjustments that wholesalers would naturally make when the market so dictates are verboten. Instead, they must wait for the government's permission, or be guilty of committing "economic crimes."[2]

As long as the market remains relatively calm, Hawaii won't have any real glitches, just as during most of the 1970s, there were no long gas lines. However, as soon as there is a disturbance in the market, whether it be a crude oil price shock, wars, rumor of wars, bad weather, or trouble at the refineries, the government "pricing" scheme quickly will fall apart.

The limits of power: $9

If gasoline shortages develop at the wholesale level, then it is almost certain that pump prices will shoot up quickly. Thus, it is very possible that Hawaii's wholesale pricing policies will cause retail prices to be higher than they would be in a free market. When this happens — and it almost certainly will — then we surely can expect the Hawaiian government to come down hard on retailers and blame them for the troubles. At that point, the legislature will slap price controls at the pump, and the shortages will continue, accompanied by gas lines and angry motorists demanding that the government "do something."

Legislatures rarely repeal bad laws just as presidents refuse to admit that their military adventures are mistakes. The oil and gasoline price controls of the 1970s began with an executive order in 1971 (as part of Nixon's "Phase One" wage and price freeze that accompanied the collapse of the Bretton Woods international monetary system), and were around for a decade before they were eliminated. One hopes that Hawaii's new system will not be in existence that long, but don't be surprised if legislators continue to ignore the free market and spit into the wind.


William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him MAIL. See his Mises.org Articles Archive. Comment on the blog.

[1]The year 1871 also saw the publication of William Stanley Jevons's Principles of Political Economy, which took a marginalist view of economic action. However, much of Jevons's analysis was mathematical, and depended upon cardinal measures of utility, unlike Menger, who saw utility as ordinal in scope. Thus, Menger's work was and is more useful.

[2] I do not know if the Hawaii law has any criminal penalties, although I would not be surprised if it did, given that lawmakers have increasingly turned toward criminal sanctions as a way to bully people into acting in accordance with the legislators' will.


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