Asymmetrical Information

OpEd on the same subject available for free on Opinion Journal.

This looks like a good opportunity to make a $5000 bet about the outcome of this policy.

You're an MBA who works for The Economist, they're politicians from Hawaii, I'm going to pick you to win this one.

I agree with your point overall, but this particular situation is slightly more complex.

First, the cap is set at a rate based on market prices in other regions. In this case, it will always be more profitable for the two refineries to produce as much gas (and other products) as they can. At some point, it could be worthwhile for them to produce and export back to the mainland, but my guess is that the price cap mechanism won't allow this opportunity.

In the longer term the price will have an impact on supply. Since they are making lower profits than mainland competitors, there is no incentive to reinvest in the business, so if the policy is maintained, shortages will results, but they would be far in the future.

Second, two refiners in a closed economy certainly gives them significant market power. I would guess that shipping product to Hawaii from either Asia or the US would add significant costs. I do thnk there may be a collusion issue, although no evidence has been presented. None-the-less, without furthur evidence one way or the other, I think it is unfair to completely rule out collusion.

According the the local paper, Hawaii's gas prices tend to lag the mainland's. Now they'll move more in concert. That has good points when gas prices are going down (Hawaii's gas tended to lag on the downslope) and bad (Hawaii's gas tended to lag on the upslope).

Don't know if it is still true, but a fair proportion of the gasoline in Hawaii had to be imported. The refinery produces a high proportion of jet fuel for the airlines and not as much gasoline.

FWIW, the membership gasoline outlets, like Costco, have (or tend to have) the lowest prices that a few gas retailers emulate to a degree (with the obvious intent of reducing the incentive for even Costco members to drive all the way to Costco to get gas). Whether there will be a general price war or competition remains to be seen, but I don't expect gas prices (retail) to really rise unusually.

We'll see.

Hmmm...perhaps they will pull this off without any significant market-damaging effects. Nonetheless, if I were living in Hawaii right now, I think I would open a bicycle shop.

Prediction; Gas prices in Hawaii will drop in the next few months, as they will drop everywhere else due to market forces. But the politicians in Hawaii will take credit for it.

I agree 100% with Randy. He has the safe bet. I first heard of this on Fox News Channel last night, with the eternally-TV-hot Laurie Dhue saying that Hawaii's politicians had solved the gas price problem by capping them. I'd like to believe it was VRWC sarcasm, but no, she read it off the teleprompter like the meant it, and because she's hot, I believed it. OK, that last part was sarcastic.

Anyway, if there's ever a suggestion that FNC is Tass for the right wing, here is your counterexample, along with every time Jeb Bush gets on FNC in the wake of a hurricane and threatens to castrate price gougers and feed their giblets to homeless aligators.

Though I generally agree with your post, I have to disagree with this:

More recently, this is basically what happened in the California blackouts

California's problems had more to do with price-fixing by a coordinated effort to shut down capacity.

I'm surprised at your prediction of a windfall for station owners, given the extremely competitive nature of that business. Prices at the pump are targetted to the penny because consumers are generally EXTREMELY price sensitive.

Maybe that's changed since I've driven a car in the US on a regular basis. But it certainly used to be the case that a consumer would drive a couple of miles further to save a penny per gallon.

Radny's got it nailed. Same thing happened years ago in Pa. - they raised the minimum wage to something less than the prevailing entry level wages and then crowed when there was no increase in unemployment. Timing is everything and the politicians seem know about when a "crisis" is about to be resolved by natural market forces.

The fundamental problem in California was that they set up a system where the average price was always equall to the marginal price. Essentially, no free market system can work when that is true.

It might be possible for the refineries to get around small discrepancies between the caps and the market price by adding delivery or other charges. Which would probably end up costing the retailers more, which would then be passed on to the customers at the pump.

Also, if the refineries can cover their variable expenses under the caps they might continue to operate for quite a while at a loss.

In point of fact, there were so many fiascos contributng independently to California's market melt down that it's impossible to isolate one or two as "the" cause.

1) The background context was one where there was a basic shortage of generating plant: Peak demand far outstripped local reliable sources of generation, and the state had been relying on power imports from Nevada and Washington for many years.

2) The paucity of local generation stemmed in part from hostility to new construction led by save-the-earthers and other anti-development types, as well as a hostile regulatory atmosphere. But that's not the whole story either: Surplus hydro-power from Washington state (cheap, cheap, cheap thoughout the 1990s) as well as cheap col-fired power from Nevada made investing in local power gen facilities a dicey propostion in any event.

What was unforseen in the early 1990s -- when new generation should (in retrospect) have been added in California -- was that growth in native load in Nevada would soak up the surplus there and that a long drought in Washington state would diminish hydro resources. Who knew?

3) Due to childish political prejudices, the liberalized market structure the state created for power trading created a playpen for the predatory. Dumb, dumb, dumb.

a) Long term power purchase agreements were forbidden so that big users (which Californians seem to see as emblematic of evil) couldn't get better deals in the market than residential cusotmers (who cost a lot more to serve).

b) The utilities were compelled to sell off almost all theri generating resources, and without long term bilaterals, they were then forced to buy the bulk of their power in the volatile short term (daily/hourly) market

c) To the degree that there were tradable power contracts with longer terms, the utilities were unwilling to buy because of fears that the expense would be disallowed under residual price regulations.

d) Utilities were still facing price caps at retail but no liimit on costs at wholesale.
Predicably, they were whipsawed. (While SG&E in San Diego had won the right to pass along costs, the state took it away retroactively when consumers complained. Some free market!)

e) The market's rules and structure contained no corrective measures for manipulation -- indeed, no real regluation at all except the presumptive "corrective" of infinite price. Everything that Enron did was legal IMHO -- they just took advantage of the system that the wise men of Sacrimento had created. To the degree that Enron had previously made fortunes that were predicated on taking the naive to the cleaners, someone in charge should caught on -- but they didn't. And when the evidence of their foolishness slapped them in the face, they attacked the market players for acting like market players. Result: Re-regulation that will last indefinitelky, and billions in debts that were created to no social purpose.

And those are just some of the highlights.

One notable point: The FERC eventually imposed some price caps ($500 per megawatt hour, then $250, then $150 -- still way more the cost of production at even the worst-performing plant) and those caps did not make a bad situation worse. Ineeed, they probably prevented creation of a few billion dollars in paper liabilities, but that's only because they were doing price regulation at stratospheric levels to begin with.

It's sort of like a rule in mini-golf that after hitting ten strokes on a hole, you are deemed to have sunk the ball: It won;t make a winner out of a loser, but it will prevent one fool from holding up the course indefinitely.

The theory that I learned, and that resonates best with me, is that wholesale price caps would raise retail prices. Just think of the lower than market wholesale price as a rent the gasoline retailers will compete to get. The actual cost to the retailers will end up being the same with or without the wholesale price cap. The wholesale price cap will cause the cost of raw materials to be a lower percentage of total cost than it otherwise would have been.

However, since the wholesalers are in one way or another going to get less for their product, they will supply less product. Less gasoline on the market implies higher retail prices.

The main question is how efficiently will the market work around this impediment. Literal queues are the most socially wasteful way, and would doubtless be a last resort. Shifting some of the anciliary services (whatever they are) of wholesaling fuel from the wholesalers to the retailers will probably be one of the first approaches (this comes under the "reducing the quality of the product" heading). Various sorts of bribery would also be more efficient.

Why would price caps necessarily force suppliers to reduce production? If the capped price were somewhere between the 'natural' market price and the break-even price (for the supplier), you'd think it would have no effect, or even force/allow the suppliers increase production to make up for lost profits.

It's an implication of the standard observation that offering more money for a product will elicit more supply. If offering more money will get more supply, then offering less will get less supply.

Why would you think that producers could increase production at a cost that is profitable at the capped price, but would choose not to do so at an uncapped price? That seems bizarre.

Here's a suggestion that oil might go to $75 a barrel because hurricane Katrina might shut down a couple of refineries. http://www.brendanloy.com/index.html#112519523370284757

I can't wait to see this fail...

"According the the local paper, Hawaii's gas prices tend to lag the mainland's. Now they'll move more in concert. That has good points when gas prices are going down (Hawaii's gas tended to lag on the downslope) and bad (Hawaii's gas tended to lag on the upslope)."

Interesting. And in which directions are gas prices moving lately?

One can see how this lag made it look particularly appealing to politicians, once they got past that whole issue of shortages, lines, etc. ('cause hey, why worry about that?). If the cap is higher than the price, it has no effect; this is the case when prices are rising, if they rise more slowly on Hawaii than on the mainland. The cap only comes into play to make prices match the mainland on the downslope, when the price would lag and be higher than the mainland. Since the cap is dynamic and based on mainland prices, it should only have an effect when mainland prices are heading down faster than Hawaii's prices.

Wouldn't it be convenient if you could just declare that prices are no longer sticky, but only in one direction?

What this will do, when and if the capped price becomes lower than the market price, is to cause the suppliers to cut back on deliveries. That is, normally they balance various costs of refining and delivering fuel against the lost profits that would be incurred by not delivering it on time. With a slightly lower price, instead they will look for ways to cut back on costs, even if it means less service. No one gets overtime pay, no matter if the broken equipment they were working on interrupts the flow. Repair parts may be sent by ship instead of by air. Maybe they lay off half of their drivers and only deliver to half of the gas stations each day.

At the gas stations, this means that the operators have less fuel than they could sell. The true free-market way to handle that is to raise the price until the market demand falls to match the supply. This lets each individual assess for herself how important it is to continue to drive, and choose whether to pay more for gasoline, use other forms of transportation, or stay home. However, station operators who do this will get called "profiteers" and all kinds of other nasty names, so it's likely that they will choose to ration gas instead. (This means, long lines, partial fill-ups, and more gas wasted waiting in line and driving around looking for a station willing to sell you more.)

But then, think of Joe's Auto Repair, which has a pump only so they can sell gas at $5.00 per gallon when an out-of-gas car is towed in.Now suddenly they can actually sell gas to non-captive customers. They aren't "profiteering" because they haven't changed their price since 1975. They need bigger allotments. The oil company dispatcher gets his car fixed for free. El Cheapo Self-Serve across the street finds that unfortunately someone "miscalculated" and the tanker is empty when it gets there...

In other words, since simply offering the oil company more money for more gasoline isn't allowed, the market adjusts in twisted ways.

this is basically what happened in the California blackouts
The California energy crisis provides evidence for and against the Hawaiian price-cap scheme.

It demonstrated how retail level price caps fail to discourage consumption when necessary. However, it also demonstrated how price caps on the wholesale level encouraged more production in the energy market: the wholesale price caps ended incentives to game the system; shutting down plants to cut supply was no longer as profitable.

If Hawaii does have a uncompetitive wholesale market, a price cap would not discourage production. However, the suppliers in this case have a strong incentive to take a short term loss by cutting supply so that price-caps are removed in Hawaii and are not imposed in other uncompetitive markets.

Recent local news says that recent refinery fire in California and hurricane Katrina may contribute to a fair size increase in West Coast gas prices (I don't recall how big, but 14 cents per gallon sticks in my mind) which would translate into increasing the wholesale cap by same. IIRC the cap is to be adjusted on a weekly basis.

I think there was a bit of irony in the article since the caps were put in place to make Hawaii's laggy market more responsive to the West Coast.

I didn't read the WSJ article (don't have access), but the Hawaii "cap" isn't going to be much of a test because the "cap" is adjusted weekly based on an index of wholesale prices of three markets on the mainland, and so is a very temporary "cap." It still might have some effects, but it won't be the blockbuster Supply-vs.-Demand Pay-Per-View Don King Battle of the Economic Theorists I live from Honolulu that anyone might be expecting.

More on Hawaii's cap and the hurricane here

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