The
state of California is experiencing a fiasco in its electric power system. The
system has repeatedly run near the overload point, necessitating brownouts and
threatening rolling blackouts. Wholesale power prices in San Diego County and
the southern portion of adjacent Orange County have briefly been as high as
$5,000 per megawatt hour and, according to one report, as high as $11,500 per
megawatt hour. At first, the local utilities in these counties attempted to
pass their greatly increased wholesale power costs on to their customers, in
the form of doubled and tripled electric bills, but the state government, in
response to widespread protest, soon prevented them from doing so. Now these
utilities are threatened with bankruptcy, having lost approximately $6 billion
dollars in the process. Out-of-state suppliers of electric power have
threatened to cut off further supplies to the state, out of fear of not being
paid by utilities on the verge of bankruptcy. At last report, these suppliers
have been ordered by the federal government’s Secretary of Energy to
continue their supplies.
Incredibly, the fiasco is being blamed on deregulation and the
establishment of a free market in electric power. See, for example, the
disgraceful article "California Screaming" by Paul Krugman in The
New York Times of December 10, 2000. The Times’ lead in to this article, which accurately conveys its
tenor, is "California’s blind faith in markets has led to an
electricity shortage so severe that the governor has turned off the lights on
the official Christmas tree."
Clearly, it is necessary to review the facts that have caused California’s
fiasco, in order to arrive at a rational judgment of its nature. This review
will establish that the actual cause of the fiasco is not at all the free
market but rather, from beginning to end, destructionist government policy, in
large part inspired by environmentalist fanaticism. Assertions, such at that
of The New York Times, which was just quoted, will be shown to
constitute a literal contradiction in terms.
Destructionist government policy has increasingly restricted the supply of
electric power in California and throughout the United States. It is
responsible for the fact that for the last twenty years or more, there have
been no new atomic power plants constructed and few or no new coal, oil, or
hydro power plants built. Indeed, it has caused existing plants of these types
to be dismantled. In California, in the last decade, only power plants using
natural gas as their fuel have been allowed to be constructed, and such plants
now account for most of the state’s generating capacity.
Because power plants using natural gas are substantially more expensive to
operate in comparison with the other types of power plants, and would quickly
be plunged into unprofitability if exposed to the competition of other types
of power plants, investors have been unwilling to invest in additional
generating capacity in California, and elsewhere, to the extent they otherwise
would have. At the same time, the government-caused dependence on natural gas
as the source of fuel for power plants has contributed to the recent sharp
rise in the price of natural gas to record levels. The rise in the price of
natural gas has been especially great in California, where lack of adequate
pipeline capacity has limited natural gas supplies more than in the rest of
the United States.
Over the same period that the government has restricted the supply of
electric power, there has been a substantial increase in the demand for
electric power. The rise in demand has been brought about both by population
growth and by the increase in power consumption per capita caused by economic
progress. An example of this last is the increase in power consumption caused
by the use of personal computers and their peripherals by tens of millions of
people.
When these facts are combined with government price controls on electric
power (which have existed since the early years of the industry), shortages
of electric power are an inevitable result. This is because the government
prevents not only the increase in supply that would keep pace with the
increase in demand but also the rise in the price of electric power that would
keep the demand for power within the limit of the supply available, however
artificially restricted that supply might be as the result of government
interference.
The government’s responsibility for shortages of electric power, it
should be realized, inescapably implies its responsibility for power brownouts
and blackouts. For their immediate cause is a demand for power too great for
the power system to supply, i.e., a power shortage.
It cannot be stressed too strongly that a shortage is an excess of quantity
demanded over supply available. And that it is caused by a government price
control, which prevents price from rising high enough to reduce quantity
demanded to the supply available, which would eliminate the shortage. Of
course, the more the government holds down the supply of electric power, the
higher is the price that is required to prevent a shortage of power. When the
government refuses to allow a price that is high enough to keep the quantity
of power demanded within the limit of the supply of power available, brownouts
and blackouts are the result.
It should be understood that when taken in conjunction with price controls
on electric power, the government’s inflation of the money supply also
contributes to power shortages. This is because inflation contributes both to
the increase in the demand for power and to the restriction of its supply. The
former results largely from the rise in money incomes that the spending of the
additional quantity of money brings about, and which gives people the
financial means to afford larger quantities of any given good at any given
price. The latter results from the fact that inflation drives up the costs of
constructing and operating power plants and thus correspondingly reduces their
profitability in the face of controlled selling prices. The process does not
have to go very far before it no longer pays to construct power plants—assuming,
of course, that the environmentalists did not prevent their construction in
the first place.
All this is the basic context of the fiasco now existing in California and
which, on the basis of a combination of ignorance and deceit, is being blamed
on, of all things, "a free market" in electric power.
The so-called free market in electric power in California consists of the
fact that, last summer, price controls were removed from the power supplies of
San Diego County and the southern portion of adjacent Orange County, while
remaining in force throughout the rest of the state. The power supplies of
this relatively small part of California were suddenly opened up to the
competition of power companies throughout the rest of the state and in
surrounding states who were desperate for additional power to avoid the
brownouts and blackouts caused by government price controls in their operating
territories. Starting last summer, by offering a higher wholesale price, these
power companies could bid away power generated in this area from use by the
area’s local residents and businesses. Locally generated power could be
retained for use in the area only at a wholesale price that matched the price
generated by this competition.
It should be understood that the power companies are in a position in which
any customer can turn on additional power-using devices, and they are obliged
to supply the additional power needed to meet that additional demand. Price
controls and the government’s restrictions (described above) preventing the
construction of new power-generating capacity now repeatedly compel the
utilities to operate close to the limit of their existing power-generating
capacity. To avoid overloading and thereby crashing their systems and causing
wide-spread blackouts, they must either find the necessary additional power or
induce other customers, typically large ones, to cut back on their power
consumption, by such means as the offer of substantial rate concessions.
Finding additional power, wherever it is available, can serve to avoid
expensive rate concessions and, worse, a system crash. This is the desperate
situation for which the limited power supplies of San Diego County and the
southern portion of adjacent Orange County were put in the position of having
to provide a remedy.
Anyone familiar with economic theory could easily have predicted that the
result would be a skyrocketing of power prices in the area. For the limited
power supplies of this small area were being made to bear the burden of coping
with the statewide and indeed, Western-states-regionwide power shortages
caused by destructionist government policies.
Now the truth is that an immediate, partial solution to the sharp rise in
power prices in this limited area is the immediate decontrol of power
prices throughout the rest of California and, indeed, throughout the whole
Western-states region, which shares a more-or-less integrated power grid. The
effect of such decontrol would be an immediate substantial increase in the
supply of electric power available for the decontrolled market and thus,
probably within days, if not hours, a sharp drop in the price of electric
power in the decontrolled market.
This increase in supply, it must be stressed, would not come from an
increase in production, though very soon there would be such an increase and
thus a further increase in supply and reduction in price in the decontrolled
market. No, it would come from the more or less substantial portion of the
already existing production of electric power that is presently consumed by
submarginal buyers, i.e., by buyers unable or unwilling to pay the
potential free-market price, which, of course, would be higher than the
controlled price still in force over the far greater part of the state. When
the price control is removed, this substantial part of the supply, presently
not available for the decontrolled market, is made available for the
decontrolled market, where its effect is to enlarge the supply and thus
correspondingly reduce the price.
Lifting price controls in the remainder of Orange County and in Los Angeles
County, for example, would add supplies from these areas to the supplies
presently available only from San Diego County and the southern portion of
Orange County to meet urgent needs for power throughout the state and the
Western-states region in general. The rise in price in these additional areas
would serve to reduce the quantity of power demanded in these areas. The
supply of power previously used to meet this portion of the demand would be
available for the now larger decontrolled market. The effect of this larger
supply in the larger decontrolled market would be to reduce the price of power
in the decontrolled market. Decontrol throughout the state and in surrounding
states would still much more substantially enlarge the supply available in the
decontrolled market and drive down the price there. Indeed, at the same time
that larger supplies were being made available to meet urgent needs for power,
decontrol would serve greatly to diminish the urgency of those needs. This is
because the rise in power prices throughout the state would serve everywhere
to reduce the quantity of power demanded and thus serve to reduce the amount
of power needed from outside sources to prevent brownouts or blackouts.
It should be clear that decontrol limited to the territory of just one or
two counties is decontrol in a very high-pressure pressure-cooker, so to
speak. It is decontrol in which all the pressure of the shortages of the whole
rest of the state and surrounding states come to bear on the very limited
supplies of power available just in this relatively small area. Decontrol over
the whole state and region would serve to eliminate all of this pumping up of
the pressure that has propelled prices so high in San Diego County and south
Orange County.
A further increase in supply and reduction in price that would result from
state-wide and region-wide decontrol would come from existing power capacity
that is presently forced off the market by price control, coming back on to
the market. That there is such capacity is confirmed by the following
statement in a recent newspaper report: "Natural-gas prices traded at
record levels Friday [December 8, 2000], hitting $60 per million British
thermal units. That prompted some gas-fueled generating plants to shut down
because they couldn’t make a profit under the ISO’s [Independent System
Operator’s—a state official] wholesale cap of $250 a megawatt hour."
(The Orange County Register, December 10, 2000, News Section 1,
p. 12. Italics added.) The elimination of price control would bring such
producers back into the market, increase the market supply, and reduce the
market price. As matters stand, the forced withdrawal of such producers serves
to further increase the pressure on the very limited supplies of the small
area that is free of controls, and to further drive up their price. For buyers
who might have been supplied by those producers, and now are not, must turn
instead to the supplies of that small area.
The preceding makes clear that the price of a good in a fully decontrolled
market is substantially less than the price of a good in an only partially
decontrolled market, and is virtually certain to be very substantially less in
comparison to the price in a partially decontrolled market as small as the one
in California has been. Full decontrol in California would mean lower power
prices both for this reason and because of the return to the market of output
from existing producers that the controls had driven away by making its
production unprofitable.
The following hypothetical example will serve to drive home the principle
that the elimination of price control on the full supply of a good available
results in a lower decontrolled price than when only a portion of the supply
of a good is free of price control. Thus imagine that the full available
supply of a good is 100 units and that at a fully uncontrolled, free-market
price of $120, the quantity of the good demanded is also 100 units. In this
case, the free-market price is $120—that is the price at which quantity
demanded and supply available of the good are equal and, consequently, neither
a shortage nor an unsaleable surplus of the good exists.
Now imagine that the government imposes a price control on this good of
$100 per unit. At this, lower price, the quantity of the good demanded becomes
greater than the 100 units of supply available. This is because now the good
can be afforded by everyone who values a unit of it above the price of $100,
whereas before only those who valued a unit of the good above the market price
of $120 could afford it. At the free-market price, all buyers not prepared to
pay at least $120 per unit would have been rendered submarginal. They would
have been excluded from the market by the $120 price. Now however, as the
result of the price control, a more or less substantial number of submarginal
buyers become admitted to the market. They can cross the lower bar of the $100
price, while they could not have crossed the higher bar of the free-market
price of $120.
Assume that as a result of the lower, controlled price, buyers are now
prepared to attempt to buy 130 units of the good. Since only 100 units of the
good are available, would-be buyers of 30 units must go away empty handed. The
efforts of these would-be buyers to buy 30 units that do not exist is the
measure of the shortage that the price control has created.
When there is a price control and shortage, the distribution of the supply
is made largely random and chaotic. That is, it becomes an essentially
accidental matter which of the buyers seeking 130 units will be
supplied and to what extent. It is entirely possible in this situation that a
full 30 units of the supply could fall into the hands of buyers who at the
free-market price of $120 would have been submarginal, that is, into the hands
of buyers who value these units below the free-market price of $120—who
value them merely above the $100 controlled price. We do not need to make such
an extreme assumption, however. Assume that the effect of the price control
and resulting shortage is merely to enable 10 units of the supply to fall into
the hands of such submarginal buyers.
Since there are only 100 units of supply available, the diversion of 10
units into the hands of submarginal buyers, means that only 90 units of the
supply remain available for buyers able and willing to pay $120 or more per
unit. Thus buyers of 10 units, who value them all above $120 are excluded from
the market. It is against the law—i.e., the price control—for them to
outbid the submarginal buyers, as they would do in a free market. The result
is that unless they are lucky, which in this case they are not, they will have
to go away empty-handed.
It is entirely possible, and we will assume it to be the case, that among
this group of excluded buyers are buyers who value a unit of the good far
above the free-market price of $120—who would be prepared to pay as much as
$1,000 for a unit of it, or even as much as $2,000. Under price controls and
shortages, even buyers with the most vital and urgent need for a good, as
these buyers can be assumed to be, may have to go away empty-handed, because
the units they seek are obtained instead by buyers who in a free market would
have been submarginal and excluded from the market by the free-market price.
Now, finally, imagine that into this situation comes the government of
California, with its "blind faith in markets," as The New York
Times has so audaciously called it. It decontrols the price of one
unit of the hundred. What happens? The price of this unit is determined by the
competition between the most desperate and second-most desperate buyer of an
additional unit who have up to now been excluded from the market by the price
control and resulting shortage. In the present example, it is determined at a
point between the $2,000 maximum potential bid of the most desperate of these
buyers and the $1,000 maximum potential bid of the second-most desperate of
these buyers. Thus, the resulting price is, say, $1,500.
It should be obvious that if instead of timidly freeing just one unit of
the supply from price control, the entire supply of 100 units were freed, the
resulting price would be far lower—it would be the $120 free-market price.
Now although, as the above example confirms, the free-market price would be
very much lower than the price prevailing in the very narrow decontrolled
market of just one and a half counties, it would still be more or less
substantially higher than the previously controlled price. Whatever it turned
out to be, its immediate effect would be to end the shortage of electric
power and thus brownouts and blackouts. This would be to the advantage of
all consumers of power—poor consumers no less than rich ones.
The establishment of a free-market price for power means that poorer
consumers are enabled to bid more for the power they need to run their one and
only refrigerator, say, than many wealthier, higher-income buyers are willing
to pay for the power needed to operate a second or third refrigerator. It
means that they are enabled to bid more for the electric power that provides
the light they need in which to read than many wealthier, higher-income buyers
are able and willing to pay for power to run their pool lights or other
outside lights. Retention of price control, in contrast, means that the
wealthier, higher income buyer has no economic reason not to go on using power
for a second or third refrigerator and for his pool lights, which serves to
deprive the poorer consumer of the power for his one refrigerator or the light
in which to read. A free market price guarantees the availability of electric
power for the truly urgent purposes of virtually everyone who has a job.
When faced with the need to restrict consumption, a free market does so by
eliminating the least important of the uses to which a good was previously
devoted, i.e., its previously marginal uses. In the present case, such uses
will probably turn out in large part to be power-intensive industrial uses in
the production of products that are unable to bear substantially higher power
costs.
To the extent that the resulting free-market price were higher than the
previously controlled price, it would operate to increase the profits of power
producers and thereby provide both the incentive and the means (the latter
through reinvestment of the profits) to increase investment in and thus
production of power. This, of course, is part of the more complete, longer-run
solution to California’s power fiasco. Obviously, it requires the removal of
obstacles to the construction of new and additional power plants, i.e., the
environmentalists must get out of the way. The freedom to construct power
plants fueled by atomic energy and by coal must be restored.
The effect of stepped up investment in and production of power would be a
reduction in the price of power and in the profitability of producing it. The
rate of profit in power production would fall from a more or less sharply
above-average rate toward the average rate. The price of electric power would
gravitate toward its cost of production plus only as much profit as required
to provide the average rate of profit, i.e., only enough profit to make the
power industry competitive with the rest of the economic system for capital
investment. While the high profits of the power industry following the removal
of price controls would be temporary, what would endure is a larger-sized
power industry.
Thereafter, in order for any power producer to earn a premium rate of
profit, he would have become an innovator in improving power production. He
would have to find ways to reduce its cost of production and/or improve what
he could transmit over power lines. But these premium profits too would be
temporary. They would come to an end as soon as competitors succeeded in
making the improvements part of the general standard of the industry. Further
high profits would have to be earned by further reductions in cost of
production and/or further improvements in quality of one kind or another, and
so on and on. The long-run beneficiaries would be the consumers of power, who
would buy their power at progressively lower real prices.
This, indeed, is the overwhelming thrust of the free market: ever lower,
not higher prices. To be sure, this result is not very obvious when prices are
expressed in terms of fiat paper money, which is comparable in its cost of
production to paper clips or pins, and which gets cheaper faster than
businessmen can make most goods and services get cheaper, with the result that
prices expressed in paper money almost always rise.
But it is very obvious when prices are expressed in terms of how many hours
or minutes of labor the average worker must put in at a job in order to earn
the price of something. Once prices are thought of in these terms, it is clear
that the real price of almost everything has been falling for generations—precisely
because of the free market and its profit motive and freedom of competition.
That is the real meaning of a free market in electric power as well.
It should now be clear that the assertion of The New York Times that
"California’s blind faith in markets has led to an electricity shortage
so severe that the governor has turned off the lights on the official
Christmas tree" is the complete opposite of the truth, and is so by the
very meaning of the terms involved.
Presenting knowledge of the actual causes of California’s electric-power
fiasco will prevent the enemies of the free market, such as The New York
Times and its columnists, from getting away with blaming the free market
for the consequences of the anti-free-market, destructionist policies they
advocate.
In the view of writers such as Krugman, there may as well never have been
any governmental restrictions on power production inspired by
environmentalism. Lack of sufficient capacity is the fault of "the
deregulated market." In Krugman’s own words: "But in the
deregulated market, where prices fluctuate constantly, companies knew that if
they overinvested, prices and profits would plunge. So they were reluctant to
build new plants—which is why unexpectedly strong demand has led to
shortages and soaring prices."
The same gentleman knows nothing of the distorting effects of price
controls on markets that are only partially decontrolled. In his eyes, the
cause of the very high power prices in San Diego County and the southern
portion of Orange County can only be "manipulation." To prove it, he
imagines the following case:
"Suppose that it's a hot July, with air-conditioners across the state
running full blast and the power industry near the limits of its capacity. If
some of that capacity suddenly went off line for whatever reason, the
resulting shortage would send wholesale electricity prices sky high. So a
large producer could actually increase its profits by inventing technical
problems that shut down some of its generators, thereby driving up the price
it gets on its remaining output."
In reality, of course, all kinds of contractual arrangements requiring
delivery of specified quantities of power at specified prices would operate to
prevent the kind of behavior Krugman imagines. Because of such contracts
covering the greater part of their output, any rise in the price of power
would go mainly to the benefit of the contract holders, rather than to the
companies generating power. The amount of output on which the latter could
obtain the benefit of a such a short-term rise in price would be too small to
make such behavior on their part worthwhile.
Putting this aside, Krugman ignores the actual, and significant fact, that
in the summer of 2000, the power companies of California were operating
dangerously close to the limit of their capacity, causing considerable fear of
the dire consequences that would result should there be any breakdown in any
of their capacity, which became all the more likely, the longer there was no
down time for necessary maintenance and repairs.
Now, in the fall of 2000, when approximately twenty-five percent of
California’s power capacity is off line, undergoing the maintenance and
repairs that could not be performed in the summer, in the face of peak demand,
Krugman suggests that this too is part of a process of
"manipulation." Perhaps he believes that the California utilities
that have been driven to the brink of bankruptcy are growing rich in this
process.
Krugman and The New York Times appear to suffer from the malady of
substituting fantasy for knowledge of reality. The seriousness of the malady
is not diminished by the fact that The Times is often able to pull it
off with a pompousness that is exceeded only by its ignorance.
*Copyright
© 2000 by George Reisman. All rights reserved.
This article originally appeared on line on the
web site of the Ludwig von Mises Institute.
It subsequently appeared in the February issue of the Mises
Institute's The Free Market and was reprinted in the 10th and
11th editions of Taking Sides, Clashing Views on Controversial
Economic Issues, Swartz and Bonello eds. (Guilford, CT:
McGraw-Hill/Dushkin, 2002 and 2004). The title of the article
was inspired by Paul Krugman’s New York Times piece "California
Screaming."
**George
Reisman, Ph.D., is professor of Economics at Pepperdine University’s
Graziadio School of Business and Management and is the author of
Capitalism: A Treatise
on Economics
(Ottawa, Illinois: Jameson Books,
1996).
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