This essay was selected from more than 260 entries in the Minneapolis
Fed's 12th annual essay contest for Ninth District high school
juniors and seniors. When the essay question was initially posed and
the image selected, the
Minneapolis Fed did not foresee the rise in gasoline prices early this
spring. All the same, the topic was indeed timely.
"... it hath been found by experience that limitations upon the
prices of commodities are not only ineffectual for the purposes proposed,
but likewise productive of very evil consequences to the great detriment
of the public service and grievous oppression of individuals ... "--Continental Congress, 1778.1
In the wake of Watergate and the Yom Kippur war, Don Roberts,
a middle-aged gas station attendant from Minneapolis was hit with a crisis
closer to home: the Arab Oil Embargo. For months, Roberts had labored
in supplying long gas lines and disgruntled consumers with fuel, only
to find that on Dec. 19, 1973, he was without a product to sell. Arms
raised in acquiescence, he conceded: "Sorry! Out of Gas." The problems faced by Roberts were a result of a failure
in the American free market system to properly allocate its resources.
Detrimental government influence of quantity demanded combined with collusive
supply withholding added fuel to a firestorm that might otherwise have
been a mere spark. The predicament faced by Roberts and thousands of other
gasoline retailers illustrates the adverse effect of interference with
free market mechanisms, ultimately helping policymakers shape their decisions
for the future and avoiding similar market failures.
The economic spiral resulting in gas shortages began on
Jan. 11, 1973, with the institution of anti-inflationary Phase III price
controls.2 Phase III, unlike
its two predecessors, was a voluntary freeze on prices. Encouraged by
winter demand, the domestic petroleum giants increased their prices of
heating oil by 8 percent and began rampant production.3 However, heating oil production left refiners unable to prepare gasoline
stocks for heavy summer demand,4 later exacerbating the gas shortage. To punish the oil companies, the
Cost of Living Council issued Special Rule #1 in March 1973, reimposing
mandatory Phase II price controls on 95 percent of the domestic petroleum
market.5 This action, freezing
the price of petroleum for all but independent refiners, prevented gas
prices from reaching a market-based supply and demand equilibrium.
The effect of petroleum price limitations became compounded
when the Organization of Petroleum Exporting Countries (OPEC) met on Oct.
17, 1973.6 During this
Kuwait City meeting, OPEC delegates recommended "that the United States
be subjected to the most severe cuts"7 to punish America's support of Israel. The resulting OPEC embargo cut
5 percent of petroleum production per month until Israel pulled out of
the Arab territories it was occupying.8 Despite OPEC's ruling, President Nixon proposed a $2.2 billion aid package
for Israel. Saudi Arabia, infuriated, cut off all shipments of oil to
the United States on Oct. 20.9 Although Mideast oil only accounted for 11 percent of U.S. consumption
in 1972, by 1973 the level had risen to 18 percent.10 The increase in American dependence combined with a 470 percent increase
in OPEC oil prices between January and December 197311 plunged the United States into a full-fledged crisis.
Had the American market been allowed to operate without
price controls, the OPEC cutbacks would not have created a shortage of
gasoline. As it was, the government set a motor gasoline price ceiling
of approximately 46 cents.12 Refiners were less willing to produce as much gasoline because of the
low ceiling price. If the price had been higher, output would have increased
because "nothing brings on production like high prices."13
Conversely, consumers were more willing to buy more gas
at the lower ceiling price than if a higher equilibrium price had been
achieved. These factors created an output shortage of 2.7 million barrels
of oil a day, or 13 percent of consumer demand.14 Gas lines, angry customers, and dry pumps were the result. In the Eastern
Canadian provinces the story was much different. These provinces were
much more dependent on imported oil than the United States, but did not
impose any price controls on petroleum, allowing gas prices and output
to reach an equilibrium position. The market cleared at a reasonable 59
cents a U.S. gallon,15 not far off from Milton Friedman's market-clearing U.S. estimate of 55
Policymakers today can learn from the failure of the U.S.
government in solving the oil crisis of the 1970s by unequivocally adhering
to laissez-faire principles. Today, as the United States is once
again faced with rising gasoline prices due to OPEC withholding petroleum
supply, economists are reiterating support for free market mechanisms.
Government needs to adhere to these economically correct solutions and
not be seduced by more popular politically correct solutions, as occurred
in 1973. Allowing gas markets to reach equilibrium output and price levels
will prevent gas lines and dry pumps. The Clinton administration has done
a fine job in allowing free oil markets, but if gas prices become too
high, the Strategic Oil Reserves should be opened to increase the supply
available to refiners, barring a major crisis. However, as with any collusive
oligopoly, eventually an OPEC member will begin to increase production
and sell at a lower price to increase its profits. Other members will
follow, increasing supply, and oil prices will fall. The market will have
been cleared with a fraction of the problems incurred in 1973.
Unfortunately, 20 years after a price ceiling on gasoline
left Don Roberts' pumps dry, government price controls are adversely affecting
the pharmaceutical industry.17 Government again is ignoring economists because politicians want lower
prices for their constituents. Such a policy is shortsighted. Virginia
Ladd, president of the American Autoimmune Related Diseases Association,
explains, "caps on drug prices won't just hurt ... research companies
... [but] some 50 million Americans with serious diseases."18 The key, as in 1973, is to let the free market system operate without
interference. Only a commitment by the government to take a long-term
economic view will allow this. Don Roberts and his pharmaceutical counterparts
would agree with economist David Kreutzer of James Madison University:
"We learned from the 1970s that price controls are very costly, ineffective,
and ultimately, disfavored. The quack who pushes snake-oil economics had
better ... leave town."19
See more information on the Minneapolis Fed's essay contest and the second place essay.
1 "Price Controls Throughout History: What Experts
Have Said." Pharma. Online posting. www.phrma.org/.
2 Allen J. Matusow, Nixon's
Economy (1998), 248.
4 Oil and Gas Journal (March 19, 1973), 27-30.
5 "World Oil Market and
Oil Price Chronologies." United States Energy Information Administration.
Online posting. www.eia.doe.gov.
6 Daniel Yergin, The
Prize (1991), 607.
8 "Multinational Oil Corporations,"
Senate Report, 144-145.
9 Henry Kissinger, Years
of Upheaval, 873.
10 U.S. Department of
Energy, Energy Information Administration, 1980 Annual Report,
49, Table 21.
11 Matusow, 263.
12 Matusow, 266.
13 Editorial, Fortune
Magazine (December 1973), 79-80.
14 William Simon, "Current
Energy Shortages Series: The Federal Energy Office," Government Operations
Committee, Senate Hearings (1974), 605.
15 Matusow, 266.
16 Milton Friedman, Newsweek (Nov. 19, 1973), 130.
17 "Why Pharmaceutical
Price Controls are Bad for Patients." American Enterprise Institute for
Policy Research. Online posting. www.aei.org.
18 See 1.