Gasoline Price Caps a Mistake

October 17, 2002

Christopher Grandy, Ph.D.

Residents of Hawaii are likely to regret the gasoline price caps adopted during the last legislative session and being debated in the current governor's race. But they are rightly frustrated by what appears to be a broken petroleum market in Hawaii. How do we address this public problem? Price caps lead to a variety of unintended consequences. A more measured response that addresses the apparent lack of competition promises to be more fruitful.

Setting the basic gasoline price by averaging prices in Los Angeles, San Franciso, and the Pacific Northwest will almost certainly waste resources. The problem is that our prices will then reflect conditions on the West Coast rather than in Hawaii. If prices on the West Coast rise for reasons independent of Hawaii (as occured during the Spring of 2002), then Hawaii consumers will pay more than they otherwise might. On the other hand, if West Coast prices fall for reasons unrelated to Hawaii, then gasoline in Hawaii will be "too cheap." Hawaii residents will consume more gasoline than is appropriate—which undermines the intention of Part II of the legislation dedicated to promoting energy efficiency.

Section 2 of the legislation titled "§486H-D Adjustments" suggests how cumbersome this process of setting prices will be: The base price is adjusted by a location adjustment factor equal to the average acquisition cost of non-refiner marketers over the previous 12-month period; but this factor cannot exceed the "reasonable cost" of importing gasoline. Then a marketing margin factor must be added that is to be adjusted by the difference between a) the 12-month average difference between the dealer tank wagon price and the bulk price, and b) the average difference between the dealer tank wagon price and the bulk price from 1994 to the current year. Neighbor Island prices are calculated differently.

Those who wrote this statue must be amazed that the interaction of market participants seems to handle these determinations smoothly in other places. How do we know that we have included all the factors that go into the determination of the price? What if we have forgotten some crucial element? Then we will find out when supplies of gasoline start running low—and prices, no matter what the regulators say—start rising.

This is a scheme for encouraging a black market in gasoline in Hawaii—a black market designed to get around the restrictions erected by this legislation. The prices in that black market will then have to also cover the costs of evasion. This is not a recipe for lowering gasoline prices to consumers.

The real problem with the caps in general is that they substitute someone else's judgement of the right price for a determination by market participants. This was essentially the model that the former Soviet Union worked on—a model that led to a surfeit of goods that people did not want and shortages of others that made waiting in lines the main activity of Soviet citizens.

There is also the problem of regulatory capture. The gasoline regulatory system is likely to evolve into something that simply protects the profits of existing companies. This is a common problem in regulated markets. There is no real entry threat under regulation. This means that under this legislation innovations are less likely to be undertaken in Hawaii, and Hawaii as a whole will become less competitive in the global economy.

The argument that oil company profits in Hawaii are too high and that this justifies price caps combines a modestly relevant fact with a disastrous conclusion. High profits normally attract competitors. That this has not happened in Hawaii suggests that something is truly amiss. Capping gasoline prices has the merit of being a bold response in an election year. But a better solution may lie in using the information generated by the State's lawsuit to identify, and attempt to alleviate, barriers to competitive entry in Hawaii's gasoline market.