Adam M. Costello : Soap Box

Market Meddling & the California Energy Crisis

Californians have recently been suffering an energy crisis, with rolling blackouts. This is one of the richest regions in the world, and we can't keep our lights on? What gives?

Some have blamed the “deregulation” of the electric power market. Actually, this market was not deregulated; it changed from being regulated to being half-regulated, with disastrous results. It's actually pretty easy to understand what happened.

First, a quick review of supply and demand. At lower prices, consumers are willing to buy more of a product, but if the price goes up, they are not interested in buying as much; they'll look for cheaper alternatives, or find ways to make do with less so they can spend their money on other things. Suppliers, on the other hand, are willing to produce more if the price goes up. At low prices, they can only afford to gather the “low-hanging fruit”, but if the price goes up, they can afford to use more expensive methods to produce greater quantities. The market will naturally settle at an equilibrium where the two curves intersect:

[supply & demand equilibrium]

If the price were below the intersection point, demand would exceed supply and consumers would compete with each other for the scarce product by offering higher prices. If the price were above the intersection point, supply would exceed demand and producers would compete with each other for buyers by offering lower prices.

The California electricity market was once in such an equilibrium. Then conditions changed, as they always do. The demand for electricity increased (that is, the entire demand curve shifted upward), presumably as a result of increasing population and a booming economy. Simultaneously, the supply went down, possibly as a result of random breakdowns of generators, bad weather, surrounding states wanting to use more of their electricity themselves, and perhaps producers withholding supply hoping to sell it later at a higher price. A free market would respond to changing conditions by simply settling at the new equilibrium point:

[new equilibrium]

In this case, if there had been a free market for electricity, there would have been no crisis. The price of electricity would have gone up somewhat, gradually, with two good effects: consumers would have been motivated to curb their appetite for electricity, and somewhat greater revenues for producers would have motivated and enabled them to increase their production to meet the demand.

Unfortunately, there was not a free market for electricity. There was a very manipulated market. Between the consumers and producers lies a middleman, the utilities, who buy electricity from the producers and sell it to the consumers. These utilities were in the unenviable position of being required by the state to sell electricity to consumers at the old low price (a government-imposed price cap), while simultaneously being required to buy that electricity at “market price”, even if the latter was higher than the former. The utilities operated for months at a loss, racking up billions of dollars of debt. Insane, you say? Indeed, no business would do something so crazy if not required by law.

So consumers, being shielded from the true cost of the electricity they were asking for, had no incentive to curb their appetite, and demanded much more than they would have in a free market. The utilities were required to pay as much as necessary to procure this amount, so the producers did whatever was necessary to supply it. In a free market no one would have been willing to pay so much, but in this manipulated market the utilities were required to.

[effect of the price cap]

Not surprisingly, this could not go on forever. Eventually, the utilities ran up against two walls: the limit of their credit, and a second price cap on how much they were allowed to pay for electricity. Producers were unable or unwilling to sell ever greater quantities of electricity for what the utilities were allowed/able to pay, and hence the utilities were unable to provide as much electricity as consumers were asking for. So consumers, instead of having time to adjust to the gradually increasing value of electricty, used it carelessly in blissful ignorance and were then suddenly hit with blackouts.

Some people have criticized the electricity producers for making large profits during this time. Ask yourself, if you ran a business and had customers who were required by law to buy your product in quantities that did not depend on the price, don't you think you'd make large profits? It would be astounding if you didn't.

Regardless of whether there existed evil forces within the industry, the primary cause of this crisis was well-intentioned but misguided forces within the government (which is a perpetual problem, because the people have allowed the government to have more power than anyone is qualified to wield). The surest way to stop the blackouts is clear and simple: allow the utilities to charge enough to cover their costs, and the market will reach an equilibrium.

But what about poor people? If the government would like to help make sure everyone can afford basic heating and refrigeration, fixing prices is the wrong way to go about it (and in fact it backfired). A less intrusive method would be to use tax money to refund a portion of the price of the first N kilowatt-hours bought by each customer each month (so that small customers would benefit more than large customers). The tax money could even come from a special tax on electricity, and could be routed back to the customers automatically by the utilities. There may already be a plan like this in place. An even less intrusive method would be to consolidate the various assistance programs for electricity, telephone, food, shelter, etc, into one simple program, like Milton Friedman's proposed negative income tax (and even less intrusive than that would be to leave it to the <gasp> private sector...).

[See also this other description of the negative income tax, and this article describing some difficulties related to cost and incentives, which I think apply to any redistribution scheme, especially a conventional welfare scheme. When a negative income tax is combined with a flat tax rate, the result is equivalent to a basic income scheme.]

[AMC]  Prepared by Adam M. Costello
 Last modified: 2003-Oct-23-Thu 05:21:56 GMT
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