September 9, 2011

The Fallacy of $2 Gas

A republican candidate for president recently added to an already confusing political platform the promise that, if elected, he/she would keep gas prices at $2 a gallon.  (I won't mention who made the statement since it would seem like I'm picking on a single individual too much).  It's important, however, to understand the implications of putting such a measure into practice.

If you've ever taken an introductory macroeconomics class, you'll know what I'm about to say.  The fact, however, that someone seeking the highest office in the country doesn't understand the implications of his/her campaign promises is disheartening.

The first point to be made is about the nature of demand as it relates to changes in price.  We as consumers—when all other features of a product are held constant—demand (or purchase) more of the product as its price falls.  The opposite, of course, is true as well: We restrict our purchases as prices rise.  This, I realize, is intuitive, especially to anyone who likes to shop and get a good deal. 

The nature of supply is equally apparent.  As prices rise for a given product, producers want to make and sell more of it as it becomes more profitable to do so.  In contrast, as prices fall, production declines.  This is especially true of oil and other commodities.  In fact, provable oil reserves are generally measured relative to their costs of production.  In other words, as the price of oil rises, the calculation of provable oil reserves increase, because now there is more oil that can be brought out of the ground profitably.

So what does this have to do with $2 a gallon gas?  The effect of enforcing such a policy would be two-fold:

·    Suppliers will restrict production, because they'll no longer make a profit on a portion of their former volume.  In other words, they will drill from only low-cost reserves.
·    Consumers will want to purchase more gas, because it has suddenly become cheap.

The overall result would be gas shortages that could only be dealt with in a few unsatisfactory ways.  One is to simply let the shortages occur and tolerate the long lines and inability to supply gas to the extent it's truly needed.  This would be destructive to the economy and likely require some sort of rationing, as was experienced in the mid-70s. 

Another solution avoids shortages but creates an equally unsettling problem.  The resolution requires the government to purchase gas at the higher market rate and sell it to consumers at the lower enforced rate.  This of course, is government involvement in the extreme and would contribute to a widening budget deficit and a diminishing of strategic reserves. 

And there you have the only two results of implementing, by fiat, a lowering of commodity prices.  We can have shortages, or government intervention that will eventually force consumers to pay through taxation anyway.  Since the proposal came from a Tea Party candidate, I have to assume that either the person has no understanding of fundamental economics, or is willing to say anything to get a few more votes.  If the Tea Party really wanted to help consumers, it would require Exxon Mobile (which paid no taxes in 2010) to pay a fair share and put some of that money in the pockets of the dispossessed. 

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