Markets Fail When You Make Them

Ok, I made a bad prediction in my previous post about gasoline coming to Georgia in the wake of Hurricane Ike. I know it was a bad prediction, because I drove to Atlanta Airport on Sunday and did not see a single gas station with petrol (although news reports say about half do). So why was I wrong, and why has the market appeared to fail? First of all, my prediction was based on the premise that the market would be allowed to work. Gas can be found in the Southeast—just not in Atlanta. Why did every station I saw in rural Mississippi and Alabama earlier this week have gas, while those in Atlanta did not? The answer is that it would be illegal to sell the gas available in the country or suburbs in Atlanta proper. The American gasoline market is not a single unified market, but a deeply fragmented patchwork of markets where federal clean air mandates dictate what types of gasoline (called boutique fuels) can be sold where. Because of its air pollution problems, only a special boutique fuel can be sold in Atlanta. After hurricanes Katrina and Rita, the federal government wisely suspended these fuel mandates and momentarily recreated a national market for gasoline. While this measure did have a temporary effect on air quality, it prevented many of the shortages that we now see today. Unfortunately, the feds did not follow this policy after Ike, but kept the mandates in place, which is the reason that Atlantans wanting to fill up either have to wait for scant fuel deliveries or dive to the suburbs or country.

Another curious going on is that when there is gas in Atlanta, prices do not appear elevated and are roughly on par with those before the hurricane. So why with all this scarcity, are gas stations charging prices close to pre-hurricane levels? The answer probably lies in the overt threats from state and federal officials that they will go after price “gougers” for selling gasoline at high prices. As I mentioned in the previous post, the Georgia price “gouging” law is fairly toothless and not even currently applicable (the governor has to declare a state of emergency for the statute to come into force). I erroneously believed that the benign nature of this law would not impede rises in Georgia gas prices and subsequently encourage conservation and supply. However, most gas station owners are either only vaguely aware of this or think the feds will get them instead. The effect has been a de facto price ceiling on gas prices in the Atlanta area, which gives motorists the incentive to snap up gas when it is available, rather than weighing much higher prices (say $8 a gallon) and buying only a few gallons at a time. This is exactly what I—and everyone else ay my neighborhood station—did when a gasoline shipment arrived. As a result, folks who would otherwise drive around with half or quarter tanks fill them up (and top them off) whenever possible. I am running with a full tank right now but would have left more for my fellow Atlantans had the price been higher. Unfortunately, the situation has unleashed my (and apparently everyone else’s) inner speculator.

Comments

[Kevin Cassidy]

*This* is the market failure we're going to be talking about? :p

What is the upside of the federally mandated boutique fuels? To your credit, you mentioned air quality, but in a minimizing way.

Following that down the rabbit hole, I have yet to hear a defense of free markets in relation to tragedy-of-the-commons where the concerns are not only resource utilization but common pollution. How would the environment fare with unregulated markets?

Are gasoline supplies discrete enough for the marginal units to work? When I go to a gas station, I fill up. The time cost of making an extra stop versus the chance the price hike is temporary enough to wear off before a few more commutes...this math has never made sense to me. The price hike would have to be as sharp and high as the stated worst-case scenario ($8/gal). Are there studies supporting the point at which people would not fill up?

[AL]

Kevin,
Great questions. Please do not get me wrong, there are many upsides to boutique fuels. For starters, a system of boutique fuels is much more desirable than mandating a single clean fuel for the entire country. Not only are many boutique fuels more cost effective than one, but the unnecessary costs of a single cleaner fuel are not imposed on areas (mainly rural) that may not need it. While there are additional costs to boutique fuels, these are born by those who also enjoy the benefits of cleaner air. I am not criticizing boutique fuels per se, but noting that their imposition fractures the national gasoline market, which makes it more difficult for the market to withstand supply shocks produced by hurricanes or other difficulties. Normally, the fractured gasoline market functions just fine—producers produce and consumers consume. However, even minor or major disruptions—whether they are caused by a hurricane or a simple pipeline leak—can cause severe price spikes or shortages. The Federal Trade Commission has conducted many investigations into seemingly bizarre spikes in gasoline prices going back three presidential administrations. However, in almost every instance the cause has been a minor problem combined with a boutique fuel. My point is that there is a time and a place for boutique fuels but after a hurricane is not one of them.

Another great question about markets and pollution. Markets cannot function without property rights, and pollution is a problem because no one owns the air (as you pointed out with the Tragedy of the Commons). If someone did own the air, then they could go to court and stop polluters from violating their property rights. If the value created by the polluters was great, then they would pay the owner of the air for the permission to pollute. In this case, not only would pollution result from the highest valued activities, but the polluters would take every step to minimize their pollution (for more on this peep the Wikipedia entry on Ronald Coase). Recent history has shown us that market-based solutions to pollution have been very effective in both limiting pollution, while maximizing value creation to society and minimizing job losses. These market-based solutions have essentially involved getting around the tragedy of the commons by introducing property rights to pollute, either in the form of pollution credits (cap and trade) or a pollution tax (sometimes called a Pigou tax). These have been wildly successful with the exception of the European carbon trading system which collapsed because while everyone was down with the trading part no one really wanted to create a cap. As mentioned, I think market-based solutions to pollution produce superior results at minimum cost. However, I will also point out that the inefficient use of energy is costly. Many firms in this country are eager to replace older equipment with more efficient, less polluting capital. Unfortunately, since the Clean Air Acts “grandfathered” in old equipment, those wanting to replace old equipment with new, more efficient works suddenly find themselves regulated under the costly Clean Air Acts. Once they do the math, they realize that it is cheaper to keep the ancient, inefficient equipment running rather than replace it with something cleaner and greener. This is just another example of the disincentives created by command and control, rather than market-based approaches to regulation.

Your last point is the most interesting a difficult to answer. Gasoline is good that economists classify as inelastic—meaning that demand responds slightly to price increases or decreases (this is due to the fact that we usually have few alternatives to driving and that adjustments, such as folks buying more fuel efficient cars, take time to occur). For example, while gas prices have doubled in the last few years, quantity demanded in the U.S. has only decreased by about five or so percent. If gasoline was a good with a neutral elasticity of one, then a doubling of price would result in a halving of quantity demanded. However, most studies estimate that the elasticity of gasoline is about .2, meaning that a halving of quantity demanded would require an increase in price of perhaps five times. At the same time, this means that even slight increases in supply would result in dramatic reduction is price. This is why the addition of a couple of million barrels of oil production would have a considerable impact on the price of oil. The $8 a gallon was an arbitrary number that I threw up, but you make a good point about the opportunity cost to you in stopping to fill up. I guess the best answer is to give a personal example. I drive relatively little, and (prior to this situation) was only adding five or so gallons at a time, but I now keep my tank very full, because I worry that I may not be able to find gas when I need it (as I did when I found myself back from a business trip two weeks ago and banging on empty). If gas was $8 a gallon, then I might re-evaluate my opportunity cost for stopping and also consider that adding some more gas later will appear on my credit card bill next month rather than this month. I guess the last point to make is that people fill up when they are uncertain. For example, during the gasoline difficulties of the early and late 70s, folks went from keeping their tanks an average of a quarter full to more than a half a tank (true, there were shortages, but people kept on topping off). So what would be peoples’ behaviour if they saw $8 a gallon gas, but also saw that all the stations had gas? In this case they would probably be less inclined to “speculation” (as in filling the whole tank) and more likely take just a few gallons at a time to tide them over until the inevitable restoration of supplies.
Anyway, I will look to dig up some studies for you, but I have written too much already. Please let me know if this answers your questions.
Sincerely,
AL

[Kevin Cassidy]

Thank you for the well-reasoned, comprehensive response. I've vaguely heard of Coasian economics over the last few years, this gives me an excellent starting point for personal study.

And now I've heard a good free market-environment defense. Well done!

Kevin

[James k Saylor]

NEED HELP.THANKS FOR THE HOLIDAY GREETING CARD LAST YEAR.NEED JOB AT TREY CORRUGATED IN WEST CHESTER OHIO.THEY SEEM TO BE HIRING.PLEASE HELP.