Low-Energy Fridays: What happens when you freeze energy prices?
A number of political candidates who promote price freezes—also called price controls—in industries like housing have recently won electoral victories. This trend makes it worth asking what will happen if the government freezes energy prices. And this isn’t hypothetical—it’s a tried (and failed) policy meant to keep energy affordable. The most notable and relevant example is the United States’ foray into price controls on energy and an array of other commodities, referred to as the “Nixon Shock.”
Back in 1971, the economy was in bad shape. Productivity was low, but high demand meant prices were rising, leading to inflation. Inflation is typically the most visible symptom of declining productivity, and people never enjoy paying more to get less. So, unsurprisingly, politicians attempted a political solution: price controls. Congress drafted legislation that gave the president the authority to implement price controls, and President Richard Nixon did exactly that.
Prices finally stabilized once price increases were essentially banned. Hooray! Except there was a new problem: Any producer of a commodity that was not profitable at the newly mandated price would incur a loss if they stayed in business. Many businesses either left the market or took desperate measures to cut unprofitable production as a result. A notable example is that some farmers resorted to drowning their chickens. In economic parlance, the outcome of the price controls was “stagflation” (stagnation and inflation).
Inflation is caused by too many dollars chasing too few goods, and the antidote is either less money or more production. Obviously, the latter is the preferred solution. But the Nixon Shock essentially put a lid on the monetary side of the inflation equation without doing anything to increase productivity. This meant the only possible outlet to reduce the inflationary pressure was to reduce production, thereby kick-starting stagflation.
While inflation reflects rising costs, stagflation reflects a wider array of weak economic conditions, including scarcity and unemployment. Unsurprisingly, given their apparent failure, price controls were allowed to expire—but not for oil.
One might think it obvious that if price controls don’t work anywhere else in the economy, then they wouldn’t work for energy, either. But oil prices were rising at the time, and many Americans feared that lifting the price controls would simply create a windfall for oil producers at their expense.
Price controls for oil remained in effect until 1981. U.S. oil production was stagnant over that period because just as stagflation hit other industries under price controls, so too did it hit the energy industry. Only businesses that could be profitable under the controlled price remained operational—typically incumbent businesses that already paid for their equipment—while potential market entrants were iced out. President Ronald Reagan had an alternative vision: Lift price controls to incentivize the entry of new producers.
News articles from the time are revealing. When Reagan made this move, gasoline prices were expected to increase substantially. Months later, gasoline prices were rapidly falling. What happened? Because producers entered the market at the higher price, the increased competition forced incumbent suppliers to cut prices to retain market share and shift to productivity increases to increase profit.
In hindsight, the lesson is obvious: Price controls deter market entry and reduce long-run productivity. Appropriate price formation is a key aspect of a healthy economy that can efficiently allocate capital to its best use. But price controls are still a very popular energy policy in much of the world, and all sorts of policies interfere in healthy price formation—notably, energy subsidies.
Economics 101 teaches that prices are formed by supply and demand. Thus, a policy that affects one of those three parts of the equation necessitates pressure elsewhere. If prices are subsidized, demand will rise to meet the lower price. If taxes are levied, demand falls. And if prices are capped, production is limited to what is profitable at that price. This is exactly what happened when the United States had price controls on energy.
Interestingly, price controls in the 1970s didn’t deliver on their intended benefit of lower prices. This is because the inelasticity of the demand shifted consumption to foreign markets. With insufficient price-controlled domestic product, Americans had to rely on more expensive foreign product that did not have a controlled price. When some of these foreign producers embargoed the United States, energy prices skyrocketed—and the resulting scarcity famously manifested in gasoline rationing.
So, while price controls sound appealing, both economic theory and history warn that they result in scarcity. The popularity of price controls largely centers on the idea that price formation comes from “corporate greed” or some outside factor. But when prices simply reflect market conditions, attempts to meddle with them always yield bad economic results.