August 2, 1991
"One Year After - The Other Battle: Supply vs. Demand"
San Jose Mercury News
By Timothy Taylor
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BROADLY speaking, there are two competing explanations for the path of gasoline prices since Saddam Hussein invaded Kuwait a year ago. The first is that big oil companies rigged the market to raise gas prices, in a greedy and unpatriotic attempt to reap high profits.

Through July 1990, gasoline prices had been bumping along around $1.10 a gallon, or a bit less. But when Saddam Hussein ordered the invasion, gasoline prices jumped to $1.25 a gallon almost instantly.

Screeching soon followed. How was it possible for free market forces to shift the price so quickly, critics demanded? After all, it takes weeks for crude oil to be shipped across the ocean and refined into gasoline, so the actual supply of gasoline could not possibly have been reduced overnight. Congress and the attorneys general of three dozen states demanded a federal investigation as to whether the oil industry was colluding to push prices higher.

The alternative view of what happened to gasoline prices stresses the role of supply and demand. This view does not deny that oil companies are profit-motivated and greedy; indeed, it insists on the point.

Always Greedy
Oil companies were greedy in July 1990, when gas was $1.10 a gallon; greedy in August 1990 at $1.25 a gallon; greedy in November 1990 at $1.38 a gallon; greedy in January 1991 at $1.25 a gallon; and greedy today at $1.14 a gallon.

But precisely because oil companies are profit-motivated, that motivation cannot help in explaining why the price of gasoline rose and then fell. It would be silly to argue that oil companies just coincidentally became much greedier when Hussein invaded Kuwait a year ago.

The market-oriented explanation for the August 1990 price surge was not a shortfall in supply, but rather a surge in demand. Many users of oil and gasoline responded to the invasion of Kuwait by trying to buy more, to assure a sufficient supply if a shortfall of oil did develop.

From several perspectives, the immediate August price increase was not large. Crude oil prices nearly doubled in August, while gasoline prices were increased by only about 15 percent that month. Moreover, oil companies' profits for the third-quarter of 1990 turned out to be quite low, because the rising price of crude had outstripped the increases at the gas pump.

Of course, August was only the first hike in gasoline prices. They floated higher in September and October, eventually topping out at about $1.38 per gallon of unleaded regular.

Did this further increase represent another coincidental surge of greed? It's more reasonable to believe that the slowly rising prices reflecting a period of slowly increasing tensions, as a war in the Middle East that could lead to severe cutbacks in oil supplies looked ever more likely. On Aug. 25, the United Nations security council approved the use of force in enforcing a land and naval boycott.

Through September and October, President Bush began talking of a "New World Order," and warships and troops from various nations began to arrive in the gulf. By the end of October, the United Nations had passed 10 resolutions, including one encouraging that evidence be collected for war crimes trials -- a fairly clear sign of where matters were headed.

The price of gasoline hung near its high until mid-December, when it fell to about $1.25. A gift from the oil companies for the Christmas season? Of course not.

The higher gasoline prices had started encouraging conservation; demand had fallen about 4 percent from the previous year. Other factors reducing driving and the demand for gasoline were recession and colder weather. Also, the higher prices (and political pressure from the Bush administration) had encouraged increases in supply.

The December drop in gasoline prices was especially striking because the federal government had increased its gasoline tax by 5 cents a gallon Dec. 1. But profit-motivated companies were now being pressured by market forces to cut prices, and they did.

Although it's hard to remember now, many people were predicting back in January that if the United States started fighting with Iraq, the price of oil would shoot through the roof. Instead, when the bombing started on Jan. 17, the price of crude instantly fell by a quarter, and the price of gasoline kept declining, too.

Of course, this sharp fall in gasoline prices didn't vanquish conspiracy theories. Instead, many of the same people who had argued in August that prices should only change slowly, because oil supplies were slow to adjust, now argued that the fall in gasoline prices should be faster. But the decline in gasoline prices matched the progress of the war. By Feb. 26, when Bush called off the ground assault as the Iraqi army collapsed, gasoline was back to $1.10 a gallon.

The gas price story for the year has an epilogue. After hanging at about $1.10 a gallon for two months, gasoline prices climbed a bit every week from mid-April to early June, going from $1.10 to $1.17 per gallon. Naturally, this brought out the conspiracy theorists again: the Associated Press filed a story that the Mercury News headlined: "Gasoline Rip-off?"

Summer Demand
But when the summer driving season increases demand for gasoline, there is often a small price increase. The price of gasoline has now eased off to about $1.14 per gallon. As a result, even with the increase in federal gasoline taxes last December (and an average increase of 5 cents in state gasoline taxes during the last year, too), the price of gasoline has risen a tad less since last July than the average inflation rate of about 5 percent.

Most people are willing to accept that changes in the conditions in the Middle East, rather than mood swings in the greediness of the oil companies, caused the swings in oil and gasoline prices of the last year.

But intellectual acceptance is different than liking it. What many people don't like is the idea of anyone -- much less the unloved oil companies -- acting in a self-interested way at a time of national struggle. Somehow, they feel that the patriotic thing to do would have been for the oil companies to hold down the price of gasoline. But from the viewpoint of society as a whole, the price rise last fall was the right thing to happen.

Consider the alternative. If the United States had reacted to Hussein's invasion of Kuwait by forcing the price of oil and gasoline to stay fixed, it would have been head-in-the-sand politics. A fixed price means that there is no special reason to conserve gasoline; no reason for the average American citizen to recognize U.S. dependence on Arab oil; no reason to feel the risk of war in the bank account; no reason for other suppliers to step up production.

If the Iraqi war machine had turned out to be as formidable as was feared and a long war had cut Mideast oil supplies, fixing gasoline prices would have kept the U.S. economy as unprepared as possible for that event.

Of course, rising gasoline prices are no fun. Watching the numbers roll over at the pump when gas was near $1.40 a gallon was enough to give me a headache. But the rising prices were instrumental in helping the U.S. economy to adjust as smoothly as possible to a real disruption, and to giving U.S. citizens an awareness that they had something at stake in the Middle East.

No Gas Lines
Higher gas prices created pain in the pocketbook. But there were no lines at gas stations; no stations shutting down at noon for lack of supplies; no rationing of gas purchases according to whether license plates were even or odd; no Soviet-style experience of trying to buy gasoline that was simply unavailable. I don't think the oil market works perfectly. I wouldn't be at all surprised if someone were to prove that oil companies manage to tweak prices temporarily in their favor every now and again.

But what is remarkable about the past year's experience of gasoline prices is that the market worked so well in reflecting the rising and falling danger of an oil shortage.

Those who are looking for conspiracy in the oil and gasoline market will always be able to find it, just as those who believe in conspiracy about the Kennedy assassination or the death of Elvis are always able to find it.

But the fact is that when adjustments are made for inflation, those same self-interested, profit-hungry oil companies are now supplying gasoline to American consumers at nearly the cheapest prices since World War II.

This reflects the basic paradox of market forces, for oil and other products as well; by and large, self-interested, profit-motivated behavior, when channeled by market forces of competition, turns out extremely well for consumers and for society as a whole.

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