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.
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
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
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?"
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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