Econ 101: Price Caps

On June 6 this year, the average price of regular gasoline in Maryland was $4.85 per gallon. Two years earlier it was $1.94 per gallon. If we assume that the cost to the gasoline producers and sellers was the same in the two periods, gas suppliers were reaping a huge profit in June. As I write this article, Maryland’s price is $3.91. Should the government impose a price cap of, say, $2.00 to take away Shell and Chevron’s excess profits?

The economics of this situation are very simple. At the $2.00 price cap people will demand more gas than they did at the $4.85 price but the supply will be the same. Thus, not everyone who wants to buy gas will be able to. How will the excess demand (supply shortage) be resolved?

If prices are not allowed to ration supply among demanders such that everyone willing to pay $4.85 gets all they want, an alternative rationing mechanism must be imposed. Ration coupons might be issued randomly, or by lottery, or by the first letter of your last name, or to friends and relatives of the government civil servants handing out the ration coupons. Unlike any of these formulas, price rationing provides the available supply to those with the most pressing need for it. Less important trips will be canceled or postponed.

The supply side of the market is important as well. Increasing the supply of most things incurs increasing costs per unit (per gallon). Suppliers of anything will produce up to the point that the cost plus normal profit of additional output matches the market’s demand price. The supply response to price increases for gasoline can be very long. At a higher price oil companies will invest more in searching for new sources and in developing them (drilling new wells, pumping and delivering the crude oil to refineries, etc.). A limited, quick response can be achieved by increasing the rate of extraction from existing wells, but this may reduce their long run capacity. At $4.85 per gallon, oil companies have a strong incentive to increase supply as rapidly as possible. At $2.00 per gallon oil companies have virtually no financial incentive to increase supply thus the unsatisfied demand will persist over time.

Price caps are a dumb idea.