Wednesday, June 13, 2007

Don’t Drink (Milk) and Drive—It’s too Expensive…

After a bike ride with our boys two weeks ago, my wife and I went to Kroger’s and were surprised to find milk at $3.35 per gallon. High gas prices have received a lot of attention in recent months. And the price of gas is much more important to the economy as a whole. But at least in our family, high milk prices are just as troubling. We don’t drive that much and with four growing boys, we drink a lot of milk. Putting it another way: a drive to the store to buy milk has become doubly painful.

The reasons for high gas prices are well-documented: high oil prices (connected to OPEC and problems in the Middle East—although a bit lower recently with the perception of increased political stability in Nigeria), increasing demand (here and abroad), domestic supply restrictions (limits on drilling for oil and constructing refineries), environmental regulations that increase costs and fragment the market, and disruptions to refinery capacity (most recently, in Venezuela, Louisiana, and Delaware).

The reasons for high milk prices are more obvious and ironically, are connected to our problems with energy. Higher grain prices (connected to the push for biofuels like ethanol) make it more costly to feed the cows. And higher fuel costs make milk more costly to transport.

Comparing the two goods, consumers are far more flexible with respect to milk. We have few close substitutes for gas (carpool, walk, stay at home), but many substitutes for milk (water, soda, juice). As a result, there is less upward pressure on the price of milk than on gas.

But the market structure for gasoline is much more competitive. It is available at more locations and the prices are prominently posted outside. So, deviations from the “market price” can be punished by customers as they simply travel to the next gas station.

In contrast, it is not surprising that milk prices would vary more, since price checking requires much more effort. In addition, milk is typically bought a few gallons at a time and is usually one of many things bought on a trip to the store. So, consumers don’t register as much concern about its price.

As an example: the day I wrote this essay, the price for 2% milk was $3.51 at the Clarksville Wal-Mart, and in Jeffersonville, $3.49 at Kroger’s ($3.09 if you have their card), $3.29 at Thornton’s, $3.19 at Sav-a-Lot, $3.12 at Meijer’s, and $2.79 at Aldi’s.

What can the government do about this sad state of affairs? Nothing has been proposed in the market for milk yet. But for gasoline, legislators in the U.S. Congress have been busy pushing a law on “price gouging”. (HR1252 passed the House with bi-partisan support; the companion bill S357 is now under consideration in the Senate.)

What are the effects of such price regulations? In the context of significant monopoly power (as with electricity), a price ceiling prevents the monopolist from exploiting his market power. As long as the ceiling is set at a reasonable level above “costs”, then the producer will earn an adequate rate of return and the consumer will be protected.

But in the context of competitive markets, price regulations distort a well-functioning market and cause problems for consumers, producers, and society as a whole. An artificially low price will decrease short-term rationing and long-term conservation by consumers—exactly the sort of behavior we should encourage if we’re concerned about “dependence” on energy. Low prices also diminish the incentives to produce and to innovate.

The net result is a “shortage”—quantity demanded will exceed quantity supplied at the regulated price. We saw this in the 1970s with long gas lines, odd rationing schemes (in Virginia, odd-numbered license plates could only buy gas on Monday, Wednesday or Friday), and gas stations routinely running out of gas.

High prices are painful, but poor policy is worse. As with most other government interventions, price restrictions are economically problematic but politically attractive—when the public doesn’t understand their consequences.