The Policy Challenge
The problems with the California energy market have recently been a fixture of news reports. While the causes have been relatively well understood, and the consequences – blackouts and sky-high prices – are obvious, there is much debate over the solution.
In the long-run,
more power plants would help the situation; and many are already on the
way. But what can be done in the short run?
Grey Davis,
the Governor of California, has been pushing a policy of limiting the prices
of wholesale electricity. Federal regulators at the Federal Energy Regulatory
Commission (FERC) have partially adopted this idea.
In general,
when markets are functioning well, economists rarely support price caps
– or any kind of price controls. I’ll take a brief look at the
basic economic arguments against price controls, and also point to a case
in which production might actually be increased by a price cap.
Interestingly,
price controls in California might be able to kill two birds with one stone
– in the short-run, it might be able to both lower price as well as
increase the quantity supplied to the energy market.
But before
we get to the good, lets take a look at why we should be wary of price caps.
What’s
wrong with a price cap?
Competitive
markets (under certain conditions) tend to “work” – that is, they tend to
produce the “right” quantity of a good or service. The amount of production
will be such that value to the consumer is greater that the cost of production
for each unit.
Government
intervention via a price control will distort the market outcome and will
thus cause the market not to work. In the case of a (binding) price cap,
sometimes called a price ceiling, the policy may cause the quantity of the
good supplied to decline. This is because sellers will have less of an incentive
to supply the good to the market.
*In the
California case, the current (6.24.01) “cap” policy is called price “mitigation” and is actually
much more complicated (see below).
At the same
time of the decline in the quantity supplied, the price cap will cause the
quantity demanded to increase. The result will be a shortage – quantity
demanded will exceed the quantity supplied.
In this
case, the reduction in the amount supplied will be inefficient for the following
reason: with the price cap, there are people willing to pay a higher price,
and suppliers who are willing to produce at the higher price. This means that
there are transactions that would benefit both buyer and seller that are
not being undertaken. The loss in value from these forgone tractions is called,
in econo-speak, a deadweight loss (DWL).
The graph
below shows the basic points from above. A perfectly competitive market
will in equilibrium achieve a price and quantity, P* and Q*. A price cap,
Pcap, will lead to a reduction in the quantity supplied to Q2. The result
is a shortage, and a decline in efficiency in the amount given by the shaded
area.
This is
the basic argument against the imposition of price controls. The problem
with this argument with respect to the situation out west is that the California
electricity seems to be far from a well functioning competitive market.
In the next
section, I’ll give an example of how price controls may actually increase
the amount of electricity supplied, and thus provide a better outcome than
the market.
*The
regulations being imposed by the FERC are not exactly a price cap as described
here. Instead the policy is called price “mitigation” which attempts to limit
price spikes in the spot market in certain circumstances. See the FERC press
releases in the links section for more details.
What’s
good about a price cap?
The previous
section looked at how a price cap might decrease quantity and hence reduce
the efficiency of the market. On the other hand, the price cap is good for
those consumers who are able to purchase electricity at the lower price.
However, in the case above, there is also a shortage – not everyone is able
to consume as much as they would like.
The previous
argument supposed that the market, before price controls, was operating efficiently.
One reason that the market may fail to achieve the efficient outcome is if
the suppliers have some degree of market power – that is, if the suppliers
have the ability to influence the market price.
There is
some evidence that this has been the case in the California energy market.
Paul Joskow,
a professor of economics at MIT, in congressional testimony stated that there
was “…abundant evidence that market power problems were exacerbating an
already bad situation.” In addition, there have been allegations that power
companies intentionally reduced the production of electricity, by shutting
down plants, in order to push prices up. See the links section below for
the news reports.
If producers
do have the ability to raise prices, then it may be the case that price controls
may actually increase the amount supplied to the market.
Without
price controls, electricity producers face a tradeoff. If they increase production,
they can sell more electricity, but the price will be forced down. Given
this tradeoff, producers have an incentive to reduce the supply in order
to get a higher price for their output and perhaps greater profits.
However,
if there a price cap is put place, the suppliers no longer have the ability
to push up the price, and thus have no incentive to reduce the quantity that
they produce!
This situation
is illustrated in the graphs below. The first graph shows a market in which
suppliers have some market power – such as when one firm has a monopoly.
The result is a decline in the quantity of electricity produced, from Q*
to Qmon, as the firm drives up the price, to Pmon, in order to maximize profits.
the firm can no longer push up prices, and so has no incentive to reduce
production. The result is a desire to have greater production, at Q (supply,
cap). So long as the price cap is sufficiently high, that is, above the marginal
cost of the producer at the unregulated level of output, MC, there will be
an increase in production.
In reality,
the market structure for electricity is more complicated, but to the extent
that there is a significant degree of market power, price controls may increase
the amount of power produced.
In addition,
market power by suppliers creates inefficiency in much the same way as the
price controls in a competitive market. By suppliers restricting quantity,
there is not enough electricity produced. In this case, price controls create
a more efficient outcome!
So perhaps
price controls aren’t so bad. However, the next section suggests a reason
why price controls may pose a long-run danger.
Prices play a very important role in determining the allocation of resources in the economy. High prices relative to costs indicate that more resources should be devoted to production in that area, and thus serve as a signal to firms to increase production or enter the market. It is therefore very important to get prices “right” so that we have the appropriate amount of resources devoted to production of the various goods in the economy.
Freely functioning competitive markets do a fairly good job of getting prices right, and so we should always be careful when imposing some rule that alters the market’s ability to find the appropriate price.
Importantly, as time goes on, as technology and other factors shift supply, and as tastes and the development of alternatives shift demand, the “right” price may change. This is what makes many price controls “ugly.” We may be good at setting a price control that does an ok job in the short-run, but history suggests that it’s much harder to figure out how prices should change over the long run.
In addition, getting the price “wrong” becomes more costly as time goes on, since resources are more mobile in the long run. We should be very wary about and kind of long-term price controls.
The California energy crisis seems to be a short-run problem, in need of a short-term solution. Price controls are generally seen (if having any benefit at all) as primarily a short-term solution, with potential harmful long-term consequences.
The “ugly” aspect of price controls comes when a short-term fix becomes a long-term policy.
Primary
sources
FERC – Federal Energy Regulatory Commission
- Commission
Extends California Price Mitigation Plan for Spot Markets to All Hours, All
states in Entire Western Region (
PDF file) - April
25, 2001 California wholesale markets (
PDF file) - June
18, 2001 Extension to Western States, 24 hours (
PDF file)
Background
On-line newshour: California Power
LA Times coverage: Power
San Francisco Chronicle: Energy
Washington Post: Energy
About.com: Electric Power Industry
Market
Power: News
La Times: Evidence of market power to reduce output to push up prices
MSNBC: Evidence of supply reductions
Washington Post: Energy Overcharge case.
Other
Testimony by Paul Joskow of MIT:
“The
causes of California’s electricity crisis are complex, reflecting a
combination of bad market design, bad regulatory design, unanticipated changes
in basic supply and demand conditions, and supplier behavior which rationally
took advantage of opportunities created by these conditions to further increase
market prices”A good
deal more inforamtoin can be found at
Prof. Joskow’s website.
A different
approach – how about a windfall profit tax?
Energy Price Controls: Been There, Done That by Robert Litan and Philip
Verleger of The Brookings Institution
Economics of Deregulated Power Markets
DOE: Status of State Electric Industry Restructuring Activity
Electric system status in CA. (From California Independent System Operator)
Filed under: Microeconomics
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