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One reason for high gas prices

| Wednesday, Sept. 20, 2006

When the railroad, the telegraph and the telephone spread across the United States in the years immediately following the Civil War, a national market was created. For the first time in our history, farmers and butchers and tailors and other business people in locales such as Boston and Biloxi faced genuine competition from firms hundreds or even thousands of miles away.

Many of these business people complained, of course. Competition is unforgiving of firms that lack the talent or the drive to satisfy consumers as fully as do firms with greater skills and dedication.

But consumers benefited enormously.

One source of consumer benefits, beside the obvious one of more choices among sellers, was "economies of scale." If a producer can manufacture products on a large scale without significantly compromising product quality and at the same time spread many of the up-front, or "fixed," costs of production over a large number of units of output, that producer can afford to sell each unit of that output at a price lower than could be charged if he produced only a smaller quantity of output.

For example, if a shirt factory with a capacity of producing 10 million shirts per year is built at an annual cost of $1 million, the owner of that factory would probably operate more profitably by producing 10 million shirts annually than by producing only a million shirts. By producing the larger number of shirts, the cost of building the factory is spread over more shirts, so that the "factory-cost" portion of each shirt is 10 cents.

If, however, the factory produced only 1 million shirts, spreading the cost of building the factory over this smaller output would mean that the "factory-cost" portion of each shirt is $1. In short, large-scale production often lowers product cost. And competition among large-scale producers lowers the prices that consumers must pay.

Allowing producers to grow large enough to exploit economies of scale is important to economic growth and consumer well-being. The railroad, the telegraph and the telephone -- by enhancing each producer's potential to serve ever-greater numbers of customers -- promoted such growth.

Obviously, not all goods and services are produced on a large scale. Some things can be produced only on a small scale. For example, personal therapy. Other things might be produced on a small scale simply because consumers prefer it that way: If every consumer insisted that his shirt be hand-stitched and custom made, the opportunity for profitably producing shirts on a large scale would disappear. Shirts would be more costly to produce and, hence, would sell at higher prices.

If consumers chose this option, though, we must conclude that the value to consumers of wearing custom-made shirts is greater that the value of the money they'd save by purchasing mass-produced shirts. Consumers are not worse off if they choose to buy more-expensive custom-made shirts.

But suppose customers would prefer to buy less-expensive shirts produced on a large scale (rather than higher-priced custom-made shirts). Clearly, if government forces consumers nevertheless to buy custom-made shirts they are made worse off. True, consumers get better shirts but they also pay more than they want to pay.

If you think that government would never force consumers to buy "boutique" products when consumers would prefer to buy mass-produced products, you're mistaken. In a new paper -- "Market Fragmenting Regulation: Why Gasoline Costs So Much (and Why it's Going to Cost Even More)" -- University of Illinois law professor Andrew Morriss and Mercatus Center scholar Nathaniel Stewart show that much of the recent rise in the price of gasoline at the pump was caused by regulations that obstruct oil-producers' abilities to produce and distribute gasoline on a large scale.

Although government started interfering significantly in the oil market in the early 20th century, Morriss and Stewart find that beginning only in the late 1980s did the EPA and state and local governments launch unprecedented requirements on how fuel is formulated: "These fuel requirements added a set of constraints to refinery operation and transportation of fuels." Significantly, "Through various State Implementation Plans (SIPs), state and local governments also imposed restrictions on gasolines sold in their jurisdictions. Although there is no comprehensive list of formulations mandated by all levels of government, there appear to be at least seventeen different formulations -- a major increase from the single standard (the lead standard) in place in the mid-1980s. In addition, some state and local governments have imposed 'biofuel' requirements."

The consequence• What would have been a national market in gasoline now is a fragmented market. Refiners are unable to take advantages of economies of scale. Consumers are denied the lowest possible prices for gasoline.

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