Economic Relation of Energy

Theory of Price Ceilings, Price and Quantity Regulation of the Crude Oil Industry

Essay, 2011

6 Pages, Grade: 2,0


The general market regulation involves direct government intervention in economic processes to achieve political goals or to correct market failures. Regulation can be implemented through guidelines, recommendations and laws. But a government-controlled influence of the price or quantity can affect the market equilibrium to which the government policies should not be aimed at. Hence it is of utmost importance that regulation in terms of subsidies, customs, price ceilings or lower price limits are used as careful as possible without neglecting the natural market forces primarily described by Adam Smith in his book "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776).

Since people are trading they are always looking for ways to make good profit out of their goods and services. To protect their countries domestic production, governments put tolls on foreign products to reduce the imports of the latter and to support domestic products. But this import tax has a rather contradictory effect: For one the government anticipates a strong domestic production with everyone buying this product rather than a substitutable foreign product. Domestic production increases indeed, but an import tax raise the price of the domestic product and lowers the price of the foreign product. This means, an import toll is good for domestic producers (foreign consumers) but bad for domestic consumers (foreign producers). An import tax is one possibility to regulating the market. But this example raises the question of governmental goals, which need to be determined before a government enforces a regulation: Do we want to protect and promote consumers or producers?

With the beginning of the Industrial Revolution in Europe, politicians started to implement regulations on the energy market since energy became more and more important to extend industrialization. Especially coal and charcoal were in greater demand than ever as an energy supplier for the very first machines which produced, for example steal, textiles and other industrial goods. With the invention of steam engines and railroads for the transportation of industrial and commercial goods, the usage of these goods and coal rose exponentially. From that point on the variety of energy sources as well as the demand of the people has changed significantly. At the beginning of the 20th century, wood became quite marginal. While oil and natural gas were catching up with coal until the 1950s they were out-competing coal until today. On top of that nuclear power entered the market and supplied additional energy. Important expense factors are the transport costs. Based on the remarkable international flows of these energy sources coal and oil have lower transportation costs than gas. But with this dependency on these few resources there lies a danger for the economy. Fast rising prices can break down whole industries and at the worst a whole country. The six recessions in the United States between 1947 and 1975 were related to fast rising prices of crude oil on the commodities markets (Viscusi, W. Kip, Harrington, Joseph E., Vernon, John M., Economics of Regulation and Antitrust. Cambridge, Mass., 2005, see fig. 18.1, p. 586). Especially during the 1970s the regulation on the oil market became a major challenge for the government to keep the state out of a recession but this happened without any significant success. In general, regulation on the oil market was often compared with price ceiling for railing industry. This misjudgment lead to oil shortages as consumers demanded more units than firms were willing to supply. Ordinary price ceiling was not assignable to any other market and needed adjustments to particular market conditions.

As I described before change in price and quantity also moves the market equilibrium (Viscusi, W. Kip, Harrington, Joseph E., Vernon, John M., Economics of Regulation and Antitrust. Cambridge, Mass., 2005, see fig. 18.2, p. 588). Figure 18.2 shows, a state- established price ceiling below the market balance usually leads to excess demand (Q’-D(P’)) and welfare loss (fbc). On the one hand in comparison to the perfect competition the consumers gain the rectangle P*dfP’ due to the fact that they just have to pay the lower price of P’ instead of P* per unit but on the other hand they lose the triangle bcd. The net gain is the difference between the triangle and the rectangle. The producers significantly lose more. Concerning the surplus of the market balance (P*cg) they lose the rectangle P*dfP’ to the consumers and the triangle dcf.

A price ceiling below the equilibrium has the same pattern on the oil market. The consequences are predictable but not with this intensity. It depends largely on the price elasticity of demand of consumers. The more consumers are demanding, at a relatively small price reduction, the greater increases the excess demand increases which also leads to a greater welfare loss. But the entire deliberation is based on the assumption that consumers cannot resell their goods or cannot resell the right to buy the good. If so, then the dead weight loss may be avoided because they would resell the good to a higher bidder on a secondary market.

Price and Quantity Regulation of the Crude Oil Industry

Although the first oil well was found in 1859 in the United States, it did not become the most important energy resource then. Not until the 1920s, crude oil took only 11% of the total amount of energy consumption.

Generally, the oil industry consists of three divisions: production, refining and distribution. The first step of production is to discover oil sources below the surface. After boring a hole, this creates a low-pressure point in the source leading the oil to spout. The final step is to extract the oil from the reservoir. The second major process is to refine the crude oil into final goods. The process will be finished with the distribution to retailers and customers including transportation and marketing. Many of the international oil companies are vertical integrated and are able to unite all three major stage of development.

It is not just that most important conglomerates such as Exxon Mobile, Shell and BP are global players on the oil market but also governments (e.g. USA on the demand side) and international organizations (Organization of Petroleum Exporting Countries, OPEC on the supply side). A further essential fact on the oil market is the high volatility over a long period. Mainly it depends on the global cyclical and future prospect. If big economies are affected by a recession, the demand for industrial products is falling and therefore the demand for oil as well. Obviously, the opposite effect occurs in a booming period. Not alone the business cycle affects the volatility but also price and supply. For instance new discoveries of oil reservoirs can increase the supply and decrease the price level. Furthermore the geographic concentration of the oil fields can cause downward shocks in cases of political instability. During the postwar period of World War II several global incidents were responsible for strong upward price jumps such the Suez Crises from 1956-57, the OPEC-Embargo and the Iranian Revolution from 1978-79 to enumerate a few (Viscusi, W. Kip, Harrington, Joseph E., Vernon, John M., Economics of Regulation and Antitrust. Cambridge, Mass., 2005, see table 18.1, p. 592). The supremacy of the United States concerning oil supply faded over the time. At the beginning in 1880 the United States of America dominated the world oil market with 88 percent. In the following years the share of worldwide production shrank to 64 percent in 1940, 34 percent in 1960 and had fallen below 15 percent in 1980. Until 1985 the share was reduced to 28 percent but afterwards rose consistently till 1990 to 44 percent.

However, consumption increased tenfold from 1900 to 1919, from 1919 to 1964 again and it reached its peak in 1977 with a percentage of 47. The shrinking of the production share and the simultaneously elevation of oil demand derives the huge U.S. dependence on foreign oil imports.


The intergovernmental organization of the Petroleum Exporting Countries (OPEC) was founded in 1960 by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. Qatar (1961), Libya (1962), United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973-1992 and until 2007) and Angola (2007) joined as well thus formed the biggest and most influential cartel in the world. Meanwhile, Indonesia and Gabon were members as well but are not anymore. Collectively all member states hold three quarters of the worldwide oil reserves from which the world derives its power resources. OPEC stresses that Saudi Arabia is the most important member because it owns the most oil. Saudi Arabia is a so called “swing producer”. With its adjusted flow rate Saudi Arabia ensures that the common settled price in the OPEC will be accomplished. Usually the amount of oil stays too far below the maximum which makes it is possible to generate an artificial high level price for crude oil. Being under international pressure, Saudi Arabia supported solved this behavior in favor for supply and demand since the 1980s. Although OPEC was not from the beginning as established as today, they increased their influence since the 1970's dramatically. In 1973 the oil price rose by $ 2.80 within weeks to almost twice as much. This happened because of the Arab oil embargo against the U.S. during the Arab-Israeli war. From that date on the OPEC and its members were aware of their dominant market position. Until 1981, they took advantage of their position, apart from some political occasions, and pushed the price per barrel to $34 per barrel. After that, due to an overproduction, a downward trend of the oil price occurred and the price recovered only because of the invasion of Iraq in Kuwait.

Regulatory History

As I have mentioned in a previous section, governments (especially the U.S.) always tried to affect the oil market for its own advantage. Until the early 1970s it was the United States itself which determined the oil price by regulating their own oil wells. But from then on there was no regulation of quantity anymore but price regulation, which the major oil companies are not contending with. The first regulation within the USA dates back to 1909 as the number of oil wells was regularized by the Oklahoma Corporate Commission. And the first allocation of an oil field was back in 1928 in Texas which regulated both number and rate of total production for each well. This economic and political approach is mentioned in the technical terminology as “Prorationing”. The aftermath concerning the black Friday of 1929 made the first intervention on the political front necessary to protect the public good. Due to the inexperience of the leaders on this issue the price of oil could not be stabilized and the country fell into an unprecedented economic crisis. The unexpected effects like hyperinflation, mass unemployment and high interest crippled not only the U.S. economy for a long time. But already in 1930 the U.S. authorities were required again to strengthen the oil price. A huge oil field that contained an optimal exploitation to 5.5 million barrels of oil was discovered in East Texas. This massive excess supply with a simultaneously fall of demand (Great Depression) led to a shock in the commodity markets. As a consequence the price of crude oil felt sharp. To avoid these large fluctuations in the future, the federal government of the United States adopted the Connally “Hot Act” in 1935 which was enacted to protect the industry from cross-bordered, smuggled oil and to stop the prices to fall rapidly. Further the distance between the oil wells was legislated by the government to avoid overproduction. Each state could define how far this should be, but usually they come to a mutual agreement about twenty acres per well- This was due to the fact that the government required a least forty acres for conservation during World War II. Immediately after World War II, another twenty-two states passed conservation laws which enabled them directly to regulate the oil production of each individual well.

By that time, the U.S. still had no influence on oil imports from other countries. However it was not absolutely necessary because they were a very large producer themselves. Thus, they could influence the international oil price by their own governmental regulations. But U.S. President Dwight D. Eisenhower knew even then that the Gulf States oil production was on the rise. He advocated a voluntary, international cap to keep the price stable. Naturally this well-intentioned call was not well received in the Arab world and was thus acknowledged with malice. Even within America his calling for a voluntary reduction of the import from the oil refiners was not implemented which led 1959 to the Mandatory Oil Import Program (MOIP). Thus they were required by law.


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Economic Relation of Energy
Theory of Price Ceilings, Price and Quantity Regulation of the Crude Oil Industry
University of Erfurt
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economic, relation, energy, theory, price, ceilings, quantity, regulation, crude, industry
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Carsten Dümichen (Author), 2011, Economic Relation of Energy, Munich, GRIN Verlag,


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