Why Not the Best?

July/August 2001 -- California's attempt to reform its electricity industry will no doubt become a textbook case of market regulation gone awry. For it is the state's recent reconstruction of its utility market, in an attempt to create some form of "regulated competition" (as one prominent energy expert calls it), that has resulted in a highly volatile system unable to ration electricity effectively when the market is somehow shocked.

That is what happened last year when a variety of factors—a drought, the price of natural gas, and unseasonably warm weather—caused a decrease in the amount of electricity produced and a spike in wholesale energy prices. When wholesale prices rose, retail prices could not follow, because of how the state had structured its electricity market.

Now, after trying for some months to keep out of California's self-imposed disaster, the Federal Energy Regulatory Committee (FERC) is attempting to keep down the cost of electricity in the state by imposing price controls on wholesale electricity throughout the western half of the country.

The notion that price caps are needed seems to be firmly rooted in an economic notion called the "theory of the second best." Formulated by Richard Lipsey and Kelvin Lancaster in a 1956 article, the theory focuses on what happens when "optimal" market conditions are not met. In short: Given a "perfectly competitive" market, the theory says, policymakers should allow supply and demand to align spontaneously, insuring that the proper amount of the good will be produced. But, if the market has to be regulated (or taxed, or meddled with by the government), then it is often better to have more extensive regulation rather than less in order to better prevent severe distortions in the market.

Concretely, since California's electricity markets have been so distorted by government regulation, the argument goes, it is preferable to have wholesale price caps than not to have them, following the theory of the second best. Without wholesale price caps, energy companies can take advantage of the many loopholes in the state's current regulatory policy, such as selling energy to out-of-state firms only to have it wired back to California at higher prices, or selling electricity for significantly higher prices on the last-minute markets rather than on the day-before markets that regulators hoped would catch on. And since price caps will prevent an increase in price on any wholesale market, the power companies would have nothing to gain by withholding electricity; the result would be an increase in the supply of electricity and easing the shortage. The only snag is to set the caps high enough above the cost of production to allow for profits and prevent firms from leaving the market.

According to a report in the New York Times of June 3, this line of thinking seems to have been embraced by many of America's most prominent economists, including Paul Joskow of the Massachusetts Institute of Technology (who has made a career of studying energy markets) and Alfred Kahn, the architect of the airline deregulation plan. These two, along with eight other economists, drafted a letter to President George W. Bush in June supporting the idea of capping the price of energy in California. And aside from these ten, other prominent economists, such as former Federal Reserve Board vice chairman Alan Blinder and former chief economic advisor Laura D'Andrea Tyson, have been pushing for more controls on California's electricity market.

(Of course, the idea of price caps is not unique to the aforementioned scholars. Perhaps the most coherent description of how price controls could work is found in John Kenneth Galbrith's brief treatise on price-fixing during the Second World War, A Theory of Price Control: The Classic Account.)

In any case, there is no reason why California needs to look to a "second-best" option while an optimal solution is obtainable. Aside from the fact that it is doubtful whether wholesale price caps can accomplish what the theorists claim, the preferred solution—a market undistorted by government regulation—can be easily enough achieved through a more thorough deregulation of the energy market. This would mean, among other things, permitting new generators to be built, lifting restrictions on the amount of power that a plant can generate, and removing price caps in the retail market. In the short-run, prices may rise (something that is certainly not politically popular), but that would serve as a signal to both consumers and producers to adjust their behavior. During an energy shortage, there should be conservation, but that is not going to happen if prices are held constant—there is no incentive for customers to consume less energy. Without a price that ensures the resource is going where it is most valued, other and cruder devices come into play, such as waiting lists, which are vulnerable to political manipulation. (Those who the politicians deem more worthy are moved to the top of the list, for example.) And if waiting lists or other such devices do not work, producers simply run out of supply.  

In the long-run, a deregulated market would allow for the entry of new firms, a possibility that would encourage suppliers to strive towards more efficient production to keep energy costs down—an outcome beneficial to us all.

On an even more fundamental level, removing price caps from both the wholesale and retail energy markets would be the most moral course of action as well as the most efficient. Even though price plays the important role of serving as a rationing mechanism in a free market, price is also a seller's reward for the free exchange of his property. Anytime the government tells a supplier at what price he can offer his services, the government has violated the supplier's moral right to trade freely with others and dispose of his property at the best possible price it will command.

In sum, if the FERC and California's elected officials are really interested in solving the energy problem, then they must abandon the "second-best" approach of price caps and work to create a truly free energy market. It is the most economically efficient and moral thing to do.

This article was originally published in the July/August 2001 issue of Navigator magazine, The Atlas Society precursor to The New Individualist.  

‍