The Free Market 8, no. 10 (October 1990)
Sometimes it seems that our entire apparatus of economic education: countless courses, students, professors, textbooks, backed up—in the case of oil pricing—by a decade of experience in the 1970s, is a gigantic waste of time. Certainly it seems that way when we ponder the near-universal reaction to the Kuwait crisis.
When Iraq invaded Kuwait on August 2 and the Bush administration quickly organized an oil embargo and military action to try to restore the hereditary emirate, gasoline prices, wholesale and retail, began going up immediately. In two days, gasoline price rises throughout the country ranged from four to 17 cents a gallon. Immediately, hysteria hit.
Wherever one turned, media pundits, the financial press, professional consumerists, politicians of all parties, the general public, even parts of the oil industry itself, the reaction was unanimous. The price increases were unacceptable, a “ripoff by Big Oil,” they constituted evil “price gouging,” and the cause was all too clear: “unconscionable greed.”
Not content with “desecrating” pristine beaches and blue water by wantonly dumping oil upon them, Big Oil, in the words of Edwin Rothschild (all over TV as energy policy director of the Naderite Citizen Action), had launched a “preemptive strike: they are doing to American consumers what Saddam Hussein did to Kuwait.” Federal, state, and local governments hastily began investigations of the “gouging.” Senator Stevens (R-Alaska) ominously predicted “gas lines by Christmas,” and Senator Lieberman (D-Conn), leading the anti-oil hawks in the Senate, declared “there is absolutely no reason consumers should already be paying more for oil and gas... it must be stopped.”
Under this bludgeoning, ARCO quickly announced a one-week freeze of gasoline, prices, and there was general talk of “voluntary” freezes by other oil companies.
We are mired, once again, in a farrago of economic fallacies. Let us start with “greed.” There is absolutely no evidence that Big Oil is any greedier than small oil, or that oil businesses are any greedier than any other firms. It is even less likely that oil businessmen, whether big or small, were suddenly seized by a monumental intensification of greed on August 2.
In fact, pricing on the market is not an act of will by sellers. Businessmen do not determine their selling prices on the basis of whether they feel greedy or “responsible” that morning. The entire apparatus of economic theory, built up over centuries, is devoted to demonstrating a great truth: that prices are set only by the demand of purchasers (how much of a good or service purchasers will buy at any given price), and by the supply or stock of the good.
Prices are set so as to “clear the market” by equating supply and demand; at the market price the supply of a good will exactly equal the amount of the good that people are willing to buy or hold. If the demand for the good increases, purchases will bid the price up; if the supply increases, the price will fall. Demanders consist of consumers, whose purchases are determined by the values they place on the goods, and various producers or businessmen, whose demands are determined by how much they expect consumers to pay for the final product. Current production, and therefore future supply, will be determined by how much businessmen expect that consumers will be paying in the future for the final product.
When Iraq invaded Kuwait, knowledgeable people in the oil market immediately and understandably forecast a future drop in the supply of oil. (In fact, as soon as Iraq began to mass troops on the Kuwaiti border a few weeks before the invasion, crude prices began to rise sharply, in expectation of a possible invasion.) Actions on the market, e. g., demands for the purchase or accumulation of oil, are not at all mechanistic: they are a function of what knowledgeable people on the market anticipate will happen.
Far from being disruptive or “unconscionable,” this sort of speculative demand performs an important economic function. If people were mechanistic and did not anticipate the future, a cutoff of Middle Eastern oil would disrupt the economy by causing a sudden drop in supply and a huge jump in prices. Speculative anticipation eases this volatility by raising prices more gradually; then, if supply is sharply cut off, speculators can unload their oil or gasoline stocks at a profit and lower prices from what they would have been. In short, speculators, by anticipating the future, help to smooth fluctuations and to allocate oil or any other commodity to its most-valued uses, over time.
The general public, media pundits, politicians, and even some businessmen, seem to have a mechanistic, cost-plus model of “just” pricing in their heads. It is all right, they concede, for each businessman to pay his costs of production and then add on some “reasonable” markup; but any price beyond that is morally condemned as excessive “greed.” But cost of production has no direct influence on prices; prices are only determined by supply and demand.
Assume, for example, that manna from heaven, an extremely valuable product, falls on some piece of land in New Jersey. The manna (extremely scarce and useful) will command a high price even though its “cost” to the landowner was zero (or is limited to the costs of advertising and marketing his find). There is no guaranteed profit margin on the free market. A businessman may find that he can onlysell his product below his costs, and thereby suffer losses; or that he can sell above costs, and enjoy a profit. The better he forecasts, the more profit he makes. That, in fact, is what entrepreneurship and our profit-and-Ioss system is all about.
Ideas have consequences; and the danger is that we will repeat the calamities of the early and late 1970s. Then, too, suddenly higher prices (caused by current and anticipated supply cutoffs) were treated as moral failures on the part ofoil men and combated by maximum price controls imposed by government.
Imposing controls to stop a price increase is like trying to cure a fever by pushing down the mercury on a thermometer. They work on the symptoms instead of the causes. As a result, controls do .not stop price increases; they create consumer ./ shortages, misallocations, and drive the price increases underground into black markets. The consumers wind up far worse off than before.· The consumer gas lines and shortages of both’ the early and late 70s were caused by price controls; and these gas lines (including the shooting of drivers who tried to muscle through the line) disappeared as if by magic as soon as gas prices were allowed to rise to clear the market and equate demand and supply.
If the politicians and pundits have their,way, there may well be gas lines by Christmas; but the cause will be they themselves, and not small or Big Oil.
