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Petroleum product price regulations: Output and efficiency effects: A comment
eo/tcy
Petroleum Product Price Regulations: Output andEfficiency Effects: A Comment
The apparent intent of regulation of the price of domestically produo~,d crude off: i s t o :redistribute rents from petroleum producers to the consumers of petro!cum products. In order for ~he lower well-head prices of crude oil brought about b y regdation.to be reflected in the prices o f petroleum products, the refining and d;~stfibution of petroleum products must also be regulated. HarveyRoush argue that the regulations on ref'ming and marketing haee the effect of making the earningsthat may be credited to capit~l a function of the volume of output produced by that capital. The purpose of their paper is to study the effects of this particular aspect of the regulations. It has previouslybeen pointed out that the regulations restrict a refiner's ability to pass through the cost of equity capital (MacAvoy, 1977'). However, the potential for increasing the return to eq uity by varying the output/ capital ~'atio has apparently not been noted or investigated. The Harvey-Roush paper makes a useful contribution in providing this simple, analytically tractable interpretation of the regulations. If the regulations had the effect of preventing refiners from earning a no!real return to equity capital, then refinery construction would presumably cease. Unless importation of refined product~ increased, shortage~ would then be expected to develop, New refineries would not be built while regulations would prevent the controlled price, from rising to clear the market. Iiarvey-Roush predict a very different result. They find that, in general, the price will rise to clear the market. Instead of deterring the construction oi" new refinzries, the regulations provide incentives for the construction of less capital intensive refineries than would be bt/ilt in the absence of r~gulations. This is an interesting prediction and one that should be amenable to empirical test. Harvey-Roush derive other conclusions which I will explore in ~omewhat more detail below. In pmticular they conclude: (1) that the long..run effects of the regulations on industry price and output are indeterminate, and (2) that the regulations place independent marketers at a disadvantage relative to inte~ated refiner-marketers. I will discuss each of these conclusions below. The third issue discussed below concerns sc)me potentially fruitful generalizations of the model.
(1) In Part I of the paper, Harvey-Roush focus on the production and factor input choices f'or ar~ i:adividual refinery. In the short-run amdysis, this procedu~e gives unambiguous rt~sults. For any given price, output is higher for each refinery than would be t~e case without regulation, and, a s a consequence, the mark~.t equilibrium price nlust necessarily be lower. When the authors turn to a n analysis of the long run, they obtain ambiguous ~results concerning output and, hence, concerning price, It is shown that ~t refinery desig~:d to produce any given output level will have a lower capital intensity in the presence of regulation than in the absence of regulation (p. 17). However, the optimum scale for a refinery in the presence of regulation may be either greater or less than the optimum scale in the absence of regulation. Hence, no implications are obtained for optimum long-run production for a refinery in the presmce of regulation as compared to Optimum production for a refinery in the absen ce of regulation. This conclusion concerning output of an individual refinery is correct. However, it is not necessary to determine how individual refinery output responds to the regulations in order to determine how the regulations affect the long-run equilibrium price. At the industry level, the, answer is unambiguous; output is reduced and the price is increased by the regulations. The intuition underlying this result is most easily understood in the context of a constant rett, rns industry in which iadiv;dual refineries have U-shaped cost curves and perfectly elastic supply' curves for input factors. Industry expansion occurs by ,eplication of the eptimam sized plant. Whether optimum plant size is increased or decreased by the regulati3ns, the average cost of production at the optimum plant size will be greater in the presence of than in the absence of regulation. This follows immediately fiom the distortion of the factor input ratio that is induced by the regulation. Long-run minimum l:,,'oduction cost in a constant returns industry in the presence of regulation clearly cannot be lower than long-run cost undc.r competitive conditions. Harvey-Roush :recognize this point for the constant returns case (Foot.. note 19) but argue that it does not apply if some refineries operate where marginal cost exceeds average cost. The issue does not turn -,n whether the output of a particular refinery is in=reased or decreased by regulation. In the long run the number of refineries is variable. Since the input mix of every refinery is distorted, every refinery ~:hat is built will have a higher minimum average cost than it would have had in the e,bsence of regulatior,. The number of refineries in the long run is dctermined by the condition that p:'ofit on the marginal refinery bc zero. The marginal ~efin,~ry will have a higher mi:aimum average cost in the presence of regulatior,, than ~:he marginal refinery wotdd h~ve had in the absence
148
o f regulation. Therefore, for the zero profit condition on the marginal refinery to be met in the presence of regulation, price must be higher. It may seem surprising that unambiguous predictions about the price and output effeo.s of regulation of the return to capital are obtained in this model, but n o t i~:. the Averch-Johnson model o f rate-of-return regulation (Baumol and Klevodck,~1971)¢ The reason is that the Averch-Johnson framework assumes a monopoly supplier, where~s t h e model in this paper assumes a competitivemarket. In the more complex model of Part II of the paper, the long-run firm output response is again ambiguous. However, ~ suspect that the effects of regulation on industry price and output in the long run are determinate in this more complex model as well. (2) Th~ purpose of Part II of the pa~)er is to investigate the effects of partial decontrol of petroleum products. The authors find that the controls induce constrained integrated refiners to cho ~se a larger sales volume at any given retail markup than they would choose :.n the absence of controls. They conclude that the resulting regulated equilibrium is one in which the marketing margin is lower than it would be in the absel~ce of controls. This, in turn, is alleged to put unconstrained independent retailers at a disadvantage. The above result is said to occur (p. 35) because integrated refiners subsidize their marketing operations by their refining operatio)~s. Thi~ explanation for their re~ult does not follow in a transparent way from their de:'ivation. In fact, the demonstration does not require that the firm be a refiner. It holds equally well if the firm sells only purchased gasoline (i.e., if G = 0 in the model). Thus, the result holds even without cross-subsidization. This suggests that the short-run marketing response in the model in Part !! is being driven by the same mechanism 'that results in increased output in the short run in the model of Part I. If both integrated refiner-marketers and independent marketers respond in the same way to the regulations, it is not dear that the regulations disadvantage one group relative to the other. If both groups are constraiqed, then both groups may suffer a reduction in profit margins in the short run as a result of the regulations. However, the regulations are said to be binding on the integrated refiners but not binding on independent retailers (p. 34). The question that must then be addressed is whether the indcp,'ndent re~.ailers are worse off by not being constrained by the regulations than they would be if the regulations were binding. It is conceivable that indepe,adent retailers would co]lecti~,ely be better off if the constraints were biadiug on them, but this se(ms unlikely. The appropriate conclusion seems to be that both refiners anJ marketers are made worse off by the regulations, and if either groap suffers
149
relative to the other it is likely t o be the integratedrefiners:that a r e m a d e relatively worse off. Independent marketers may sell a smaller- proportion of industry sah~, but it does not follow that their profits are ~reduced relative to profits of integrated refiner-marketers. To support their claim that the regulations damage: independent marketers more than integrated refiner-marketers, Ha~ey~Roushargue (~ootnote 30) that unconstrained marketers would be b e t t e r o f f i f they couldinte, grate with constrained refiners. This is not obviotts. First, as noted above, the regulations induce all retail fLrms that are cor~strained - w h e t h e r or not they are also ret'mers - to increase their retail sales volume. I f constrained firms tend to be integrated, this fact needs to be explained. One potential explanation is simply that enforcement of the regulations has been more stringent in the case of large integrated firms than for independent retailers. This would not support the view that it is the independent retaile:rs who are most disadvantaged by the regulations. Second, it may be that the combined profits of a con'-trained unintegrated refiner and an unconstrained independent retailer would be higher if they were integrated. This need not imply that profit o n retailing would be higher. Rather, it would seem to suggest that the gain to the refining activity from integration would exceed the loss to the retailing acti'hty. Absent such integration, it may be the unintegrated refiner rather than ~:he independent retailer who is disadvantaged by the regulations. (3) In studying the effects of partial decontrol, the authors focus on the; controlled product, gascdine. The effects of the regulations on the market for the uncontrolled product are not investigated° Sinfilafly, the effect of the regulations on the price of purchased gasoline is cot studied. Conclusions about the effects of regulations on the controlled product depend on the way in which the price of purchased gasoline and the price of the uncontrolled product are affected by the regulations. As a result, very few uaambiguous predictions can be expected from the analysis. I believe that the mode~ should be broadened to simultaneously study l'.ow the regulations affect the price of purchased gasoline and the retail prices of the controlled and uncontrolled product. Inferences about the output response of individual refiners or marketers may be ambiguot, s, but the impact of the regulatiens on the long-run industry equilibrium can be expected to be more conclusive.
150
References.
Baumol, W., and Klevorick, A. (1970) Input Choices and Rate-of-Return Regulation: An Overv,:ew of.the Discussion. Bell Journal, 1, 2:162-190. MacAvoy, P.W. (I977)
Federal Energy Administration American Enterprise Institute.
151
Regulation, Washington:
Petroleum Product Price Regulations: Output andEfficiency Effects: A Comment
The apparent intent of regulation of the price of domestically produo~,d crude off: i s t o :redistribute rents from petroleum producers to the consumers of petro!cum products. In order for ~he lower well-head prices of crude oil brought about b y regdation.to be reflected in the prices o f petroleum products, the refining and d;~stfibution of petroleum products must also be regulated. HarveyRoush argue that the regulations on ref'ming and marketing haee the effect of making the earningsthat may be credited to capit~l a function of the volume of output produced by that capital. The purpose of their paper is to study the effects of this particular aspect of the regulations. It has previouslybeen pointed out that the regulations restrict a refiner's ability to pass through the cost of equity capital (MacAvoy, 1977'). However, the potential for increasing the return to eq uity by varying the output/ capital ~'atio has apparently not been noted or investigated. The Harvey-Roush paper makes a useful contribution in providing this simple, analytically tractable interpretation of the regulations. If the regulations had the effect of preventing refiners from earning a no!real return to equity capital, then refinery construction would presumably cease. Unless importation of refined product~ increased, shortage~ would then be expected to develop, New refineries would not be built while regulations would prevent the controlled price, from rising to clear the market. Iiarvey-Roush predict a very different result. They find that, in general, the price will rise to clear the market. Instead of deterring the construction oi" new refinzries, the regulations provide incentives for the construction of less capital intensive refineries than would be bt/ilt in the absence of r~gulations. This is an interesting prediction and one that should be amenable to empirical test. Harvey-Roush derive other conclusions which I will explore in ~omewhat more detail below. In pmticular they conclude: (1) that the long..run effects of the regulations on industry price and output are indeterminate, and (2) that the regulations place independent marketers at a disadvantage relative to inte~ated refiner-marketers. I will discuss each of these conclusions below. The third issue discussed below concerns sc)me potentially fruitful generalizations of the model.
(1) In Part I of the paper, Harvey-Roush focus on the production and factor input choices f'or ar~ i:adividual refinery. In the short-run amdysis, this procedu~e gives unambiguous rt~sults. For any given price, output is higher for each refinery than would be t~e case without regulation, and, a s a consequence, the mark~.t equilibrium price nlust necessarily be lower. When the authors turn to a n analysis of the long run, they obtain ambiguous ~results concerning output and, hence, concerning price, It is shown that ~t refinery desig~:d to produce any given output level will have a lower capital intensity in the presence of regulation than in the absence of regulation (p. 17). However, the optimum scale for a refinery in the presence of regulation may be either greater or less than the optimum scale in the absence of regulation. Hence, no implications are obtained for optimum long-run production for a refinery in the presmce of regulation as compared to Optimum production for a refinery in the absen ce of regulation. This conclusion concerning output of an individual refinery is correct. However, it is not necessary to determine how individual refinery output responds to the regulations in order to determine how the regulations affect the long-run equilibrium price. At the industry level, the, answer is unambiguous; output is reduced and the price is increased by the regulations. The intuition underlying this result is most easily understood in the context of a constant rett, rns industry in which iadiv;dual refineries have U-shaped cost curves and perfectly elastic supply' curves for input factors. Industry expansion occurs by ,eplication of the eptimam sized plant. Whether optimum plant size is increased or decreased by the regulati3ns, the average cost of production at the optimum plant size will be greater in the presence of than in the absence of regulation. This follows immediately fiom the distortion of the factor input ratio that is induced by the regulation. Long-run minimum l:,,'oduction cost in a constant returns industry in the presence of regulation clearly cannot be lower than long-run cost undc.r competitive conditions. Harvey-Roush :recognize this point for the constant returns case (Foot.. note 19) but argue that it does not apply if some refineries operate where marginal cost exceeds average cost. The issue does not turn -,n whether the output of a particular refinery is in=reased or decreased by regulation. In the long run the number of refineries is variable. Since the input mix of every refinery is distorted, every refinery ~:hat is built will have a higher minimum average cost than it would have had in the e,bsence of regulatior,. The number of refineries in the long run is dctermined by the condition that p:'ofit on the marginal refinery bc zero. The marginal ~efin,~ry will have a higher mi:aimum average cost in the presence of regulatior,, than ~:he marginal refinery wotdd h~ve had in the absence
148
o f regulation. Therefore, for the zero profit condition on the marginal refinery to be met in the presence of regulation, price must be higher. It may seem surprising that unambiguous predictions about the price and output effeo.s of regulation of the return to capital are obtained in this model, but n o t i~:. the Averch-Johnson model o f rate-of-return regulation (Baumol and Klevodck,~1971)¢ The reason is that the Averch-Johnson framework assumes a monopoly supplier, where~s t h e model in this paper assumes a competitivemarket. In the more complex model of Part II of the paper, the long-run firm output response is again ambiguous. However, ~ suspect that the effects of regulation on industry price and output in the long run are determinate in this more complex model as well. (2) Th~ purpose of Part II of the pa~)er is to investigate the effects of partial decontrol of petroleum products. The authors find that the controls induce constrained integrated refiners to cho ~se a larger sales volume at any given retail markup than they would choose :.n the absence of controls. They conclude that the resulting regulated equilibrium is one in which the marketing margin is lower than it would be in the absel~ce of controls. This, in turn, is alleged to put unconstrained independent retailers at a disadvantage. The above result is said to occur (p. 35) because integrated refiners subsidize their marketing operations by their refining operatio)~s. Thi~ explanation for their re~ult does not follow in a transparent way from their de:'ivation. In fact, the demonstration does not require that the firm be a refiner. It holds equally well if the firm sells only purchased gasoline (i.e., if G = 0 in the model). Thus, the result holds even without cross-subsidization. This suggests that the short-run marketing response in the model in Part !! is being driven by the same mechanism 'that results in increased output in the short run in the model of Part I. If both integrated refiner-marketers and independent marketers respond in the same way to the regulations, it is not dear that the regulations disadvantage one group relative to the other. If both groups are constraiqed, then both groups may suffer a reduction in profit margins in the short run as a result of the regulations. However, the regulations are said to be binding on the integrated refiners but not binding on independent retailers (p. 34). The question that must then be addressed is whether the indcp,'ndent re~.ailers are worse off by not being constrained by the regulations than they would be if the regulations were binding. It is conceivable that indepe,adent retailers would co]lecti~,ely be better off if the constraints were biadiug on them, but this se(ms unlikely. The appropriate conclusion seems to be that both refiners anJ marketers are made worse off by the regulations, and if either groap suffers
149
relative to the other it is likely t o be the integratedrefiners:that a r e m a d e relatively worse off. Independent marketers may sell a smaller- proportion of industry sah~, but it does not follow that their profits are ~reduced relative to profits of integrated refiner-marketers. To support their claim that the regulations damage: independent marketers more than integrated refiner-marketers, Ha~ey~Roushargue (~ootnote 30) that unconstrained marketers would be b e t t e r o f f i f they couldinte, grate with constrained refiners. This is not obviotts. First, as noted above, the regulations induce all retail fLrms that are cor~strained - w h e t h e r or not they are also ret'mers - to increase their retail sales volume. I f constrained firms tend to be integrated, this fact needs to be explained. One potential explanation is simply that enforcement of the regulations has been more stringent in the case of large integrated firms than for independent retailers. This would not support the view that it is the independent retaile:rs who are most disadvantaged by the regulations. Second, it may be that the combined profits of a con'-trained unintegrated refiner and an unconstrained independent retailer would be higher if they were integrated. This need not imply that profit o n retailing would be higher. Rather, it would seem to suggest that the gain to the refining activity from integration would exceed the loss to the retailing acti'hty. Absent such integration, it may be the unintegrated refiner rather than ~:he independent retailer who is disadvantaged by the regulations. (3) In studying the effects of partial decontrol, the authors focus on the; controlled product, gascdine. The effects of the regulations on the market for the uncontrolled product are not investigated° Sinfilafly, the effect of the regulations on the price of purchased gasoline is cot studied. Conclusions about the effects of regulations on the controlled product depend on the way in which the price of purchased gasoline and the price of the uncontrolled product are affected by the regulations. As a result, very few uaambiguous predictions can be expected from the analysis. I believe that the mode~ should be broadened to simultaneously study l'.ow the regulations affect the price of purchased gasoline and the retail prices of the controlled and uncontrolled product. Inferences about the output response of individual refiners or marketers may be ambiguot, s, but the impact of the regulatiens on the long-run industry equilibrium can be expected to be more conclusive.
150
References.
Baumol, W., and Klevorick, A. (1970) Input Choices and Rate-of-Return Regulation: An Overv,:ew of.the Discussion. Bell Journal, 1, 2:162-190. MacAvoy, P.W. (I977)
Federal Energy Administration American Enterprise Institute.
151
Regulation, Washington: