A cap on the price of gasoline is a bad idea…

And the Nintendo Wii can tell us why.

First, let’s back up a bit and describe how the market for gasoline works. Gasoline is a commodity (gasoline from Shell is effectively the same as gasoline from Exxon), and everyone knows the price (due to those giant signs on the side of the road). This means that we can model the gasoline market using basic economics and we should be able to draw some reasonable conclusions. Ready?

Supply and Demand Curves

Let’s talk about supply and demand. We all know that the “law of supply and demand” somehow determines prices apparently – but what exactly is happening? Well, let’s start with a “demand curve”.

This describes how much consumers would want (demand) for a certain price. A typical gasoline demand curve can be seen on the right – if the price is really high (Point A), we’ll only use a car for essential trips (low demand). If the price goes down (Point B), we’ll use more and more until we’re driving everywhere. Sound reasonable?

Now let’s look at supply curves. These curves describe the behaviour of the other side – the guys that produce gasoline. If the price of gasoline is really low (Point C), you’ll only sell it if you can cover your costs (generally). As the price of gasoline increases (Point D), more and more supply is available. This is a result of higher prices allowing higher cost methods to be effective. If a new extraction method costs 50 bucks a barrel, you better be able to sell it for more than 50 bucks or else there’s no point. An example supply curve is on the left.

Market Price

So we have a supply curve, and a demand curve – so what? Well, now we know what the price of gas is! How exactly? Well, let’s put the supply curve and the demand curve overtop of each other. We can see this on the right – any ideas of what the price of gas is?

If you guessed where the two curves cross, good work! Where the two curves cross gives us:

1. the price of gas
2. the amount of gas sold

It’s the single point where consumers demand the exact same amount that producers want to provide. If the price was lower, consumers would want too much and producers wouldn’t produce enough (scarcity). If it was higher, consumers wouldn’t want as much gas and producers would produce too much (surplus).

Now we know how to determine market price. Now ask yourself – what happens if someone (perhaps the government creates a law) says “Nope! That price is wrong! Change it!”.

Price Ceilings

There are a few different terms for this, but we’ll limit ourselves to an enforced maximum price – called a price ceiling. There are two different ways a price ceiling can be implemented.

The first is rather boring – called a nonbinding price ceiling. For example, if gas was currently selling at 3\$ and a law was made saying the maximum price is 4\$, what do you think would happen? Well, not much is right. It would really only come into effect if prices continued to rise.

So what’s the other type? It’s called a binding price ceiling. Suppose gas was currently selling at 3\$ and a law was made saying the maximum price is 2\$ – clearly something is going to happen. From our previous discussion about supply and demand curves we know two things happen when price decreases:

1. consumers can afford more, so demand goes up
2. producers make less money, so supply goes down

Wait a second… that doesn’t seem to make sense. We have more demand, and less supply? That seems to mean that prices would go up. But they can’t because the law says they can’t. So what happens?

Excess Demand

Well, not much can happen. It’s the law after all. Prices will stay at the price ceiling, but look at the graph on the right. The quantity demanded by consumers used to be the same as that provided by producers – but now consumers want far more and consumers provide far less. This difference is called “excess demand”.

So what happens if you have excess demand in a market? Well, let’s ask the Nintendo Wii.

Nintendo Wii

First off, the situation with the Nintendo Wii isn’t purely a result of a price ceiling. It’s very similar however (limited production capacity combined with a price ceiling). Let’s create the supply curve for Nintendo Wiis. Assume we sell at a constant price (suggested retail price), and the factory can produce up to a certain number of units – but no more.

Now let’s put a consumer demand curve over that (right) – we can see that the curves cross and an equilibrium price is produced. Consumer demand at equilibrium is less than the factory capacity, the suggested retail price is appropriate and everything works out wonderfully.

Now suppose that your executives completely underestimated consumer demand, and are now so far behind that they cannot possibly build a factory in time to satisfy this demand. The demand curve shifts to the right significantly (for a given price there is now much more demand). The Nintendo Wii factory can only produce so much however, and we can see excess demand in the graph on the left. Now we have a problem – if you’re going to make something cheap, there better be a lot of it!

Why you don’t want the gasoline market to act like the Wii market

Both situations involve excess demand. And the problems that occur are effectively identical. For instance:

• If you’re first in line, you’re golden! No problems, you get your (Wii/gasoline) for a cheap price. Unfortunately, if you’re at the end of the line, no (Wii/gasoline) for you! The market chooses based not on willingness to pay, but on willingness to screw around and hunt for a scarce item.
• People try to play the system. If they’re at the front of the line, people will buy (a Wii/gasoline), and then try to sell it for a higher price to those at the end of the line.
• The excess demand still hasn’t gone away. Everyone still wants (a Wii/gasoline). Now it’s just a huge pain to find.

For instance, you could be working a 9-5 job, which requires gas to drive to. You don’t have time to figure out what stations have gas – so you end up buying gas on the black market at a ridiculous price from a seedy guy who spends his entire day wandering around finding gas stations that actually have gas. Not exactly a shining example of capitalism.

So what has the Nintendo Wii taught us in regards to gasoline pricing?

Lessons

Price caps on markets like gasoline don’t solve a damn thing. They sound like a good idea at the start – but the very act of regulation changes the way the market works, and causes an unintended result, shortages. These shortages then tend to reward speculation instead of real investment and progress.

In short, gasoline is expensive because we can’t live without it, and continue to pay whatever price is demanded. Real solutions for transportation and infrastructure aren’t as simple as saying “gas should be cheap, always!”.

“Those who cannot remember the past are condemned to repeat it.” -George Santayana