Wholesale Gas Caps: An Economic Experiment in Hawaii.--

I hadn't realized until I read Jane Galt that the Hawaii gas price controls are on the wholesale price of gas, not the retail price. That is really shocking, because economic theory would suggest that prices are set by supply and demand, not simply cost.

If the wholesale cap is set above the market price, then the caps should have no effect whatsoever.

If the wholesale caps are set below the wholesale market price, the one thing that won't happen is that more gas will be supplied than if the wholesale prices were higher. If somehow supply were unchanged, theoretically there should be almost no difference in retail prices; the gas station owners should pocket the difference. As Galt points out, there may be some political pressure to lower prices a bit, so it is not impossible that prices would fall some, but there is no strictly economic reason for this, absent fear by gas station owners of more government regulation and interference with profits.

Yet standard economic theory would suggest that, if wholesale prices are set below market wholesale prices, the supply would fall. If there is any excess refining capacity anywhere else, the gas refiners would rationally move the gas to those other refineries, since they could get the full market wholesale price elsewhere. We would expect to see shortages, leading to higher retail prices in Hawaii, not lower ones. If supply drops and somehow retail prices stay the same, one would expect to see gas lines and rationing.

The entire proposal is based on the economic system having relatively high transaction costs of moving sales or production elsewhere. Without transaction costs, there would be little reason to sell gas in Hawaii for $2.16 if the same gas could be costlessly sold instead for $2.20 elsewhere.

The Oil & Gas Journal says there are two refineries in Hawaii. Opinionjournal says that even the agency enforcing the law expects it to increase gas prices:

The law, set to take effect Sept. 1, ties the price of gas to the wholesale price of gasoline at three price points on the U.S. mainland.

Charged with the unenviable job of implementing the gas-cap program, Hawaii's Public Utilities Commission says local industry expects the caps to increase prices by an estimated 30 cents a gallon, with costs on Oahu rising from the current price of $2.68 a gallon to more than $3. PUC says industry leaders also expect more shortages (especially in remote areas), the closure of one of two oil refineries, the halting of wholesale marketers' operations, and reduced investment in the state after the caps go into effect. Owners of gas stations on remote neighboring islands say prices will likely soar after Sept. 1, from just over $3 a gallon to more than $4.

Both refineries are saying that they will continue to operate for the time being, e.g:

"We will continue to do business as usual until such time as the situation requires us to do something different," said Albert Chee, a Chevron spokesman in Hawaii.

"Having said that, we continue to believe the law is flawed and is not in the best interests of the state. We continue to be concerned about the potential for adverse, unintended consequences."

Tesoro, meanwhile, said it had "ample supply" in Hawaii distribution and that its local refinery was operating at full capacity, indicating it didn't expect to run low on gas in Hawaii.

This is a nice test of economic theory, though if refineries are working at nearly full capacity, the economic effects may not be as large in the short run as simple price theory (in the absence of transaction costs) would suggest.

UPDATE: If you are interested in more sophisticated analyses (including relaxing my assumption that the actual amount of gas supplied would not rise with caps), you should read the comments below.

In addition, lower court opinions in Lingle v. Chevron (Sup. Ct. 2005) say that there were 6 gas wholesalers in Hawaii.

2D UPDATE: Brian at Backseat Driving argues in opposition that the analysis I recount "fails to consider whether a standard market exists for wholesale gas, just noting without comment that there are 2 refineries and 6 wholesalers, which is nothing like a standard market. Standard monopoly theory, on the other hands, says the wholesalers could be price-gouging retailers, and caps that limit the gouging will not limit the overall gas supply."

As I said, this should be an interesting experiment.