Full text of Business Review (Federal Reserve Bank of Philadelphia) : October 1974

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October

An Economic Com pact for the Latter 70s
W h y America's O il Supply Depends
On High-Priced Foreign Sources
Shortages: A Necessary Evil of the Future?

FEDERAL RESERVE BANK of PHILADELPHIA
■

•




•

IN THIS ISSUE . . .
An Economic Compact for the Latter '70s
. . . An econom ic strategy aimed at boosting
the ability to produce, bringing down infla­
tion, and aiding the disadvantaged should
provide the necessary ingredients for a
healthier econom y and society in the second
half of the 70s.

W hy America's Oil Supply Depends
On High-Priced Foreign Sources
. . . America's domestic oil consumption is
outpacing its output domestic crude, refining
capacity, and refined oil production, thereby
accelerating the nation's growing depen­
dence on oil imports.

Shortages: A Necessary Evil of the Future?
. . . Empty shelves at the grocer and less gas
at the local pump are more likely to result
from price controls than from long-term
resource shortages.

On our cover: Graem e Park, located about a mile west of US 611 near Horsham, Pennsylvania,
affords an insight into the life of an eighteenth-century American "country gentlem an" and his
family. The "Long H ouse" pictured here was built by Provincial G overnor W illiam Keith in 1721-22.
Thomas Graeme, a noted Philadelphia physician and Pennsylvania Supreme Court justice, bought
the property in 1739. Lovely and picturesque in its rural setting, Graem e Park provides the modern
visitor with an unusual glimpse of the ingenuity of colonial Pennsylvanians. (Photo by the Penn
sylvania Historical and Museum Commission, Harrisburg, Pa.)

BUSINESS REVIEW is produced in the Department of Research. Editorial assistance is provided by Robert
Ritchie, Associate Editor. Ronald B. Williams is Art Director and Manager, Graphic Services. The authors will be
glad to receive comments on their articles.

Requests
http://fraser.stlouisfed.org/ for additional copies should be addressed to Public Information, Federal Reserve Bank of Philadelphia,
Philadelphia, Pennsylvania 19105. Phone: (215) 574-61 15.
Federal Reserve Bank of St. Louis

An Economic
Compact for the
Latter '70s
By David P. Eastburn, President
Federal Reserve Bank
of Philadelphia

In the second half of the '70s we are likely to
see considerable economic conflict. The form
may be increased labor disputes, consumer pro­
tests, and other venting of frustrations that build
pressure for drastic action by government offi­
cials. The underlying cause will be conflict over
shares of the gross national product. How divi­
sive this conflict turns out to be will depend on
how intelligently and decisively government of­
ficials come to grips with the sources of it.
One can imagine, on the one hand, a scenario
in which economic policymakers will be ineffec­
tive in reducing inflation and the inequities that
go with it. Those who ordinarily benefit from
inflation will gain even more than they have up
to now; those who tend to lose out from inflation
will suffer still further. One of the most insidious
evils of inflation is that it pits one group against
another, forcing each person to look out for him­
self regardless of the consequences for others.




The resulting conflict could be traumatic indeed.
A different scenario, on the other hand, envi­
sions a set of policies that meet the needs of
upper-, middle-, and lower-income groups in
such a way that each is more or less content with
how the national product is divided. This
scenario envisions, to borrow a term from cur­
rent British policy, a compact in which all three
income groups agree to a common course of
action.
The need to reach such a compact will be
especially acute because the G N P is likely to
grow relatively slowly in the foreseeable future.
If, as in the first scenario, inflation is not con­
trolled or its effects mitigated, the outcome a few
years down the road may be a thoroughly dis­
rupted and demoralized economy. Such an
economy would likely produce an actual de­
cline in output much more severe than expe­
rienced so far this year. A policy of continuing
3

OCTOBER 1974

BUSINESS REVIEW
to fight inflation, however, also means slow
growth. Just as our current inflation took some
nine years to develop, it will take at least a
couple of years to unwind. Persistent and de­
liberate policies to moderate growth of the
economy will be essential.
In either case, various groups in our society
will be competing for slices of a slowly growing
G N P pie. When output is growing rapidly and
there is more to go around, everyone can be
more or less satisfied. With slow growth, atten­
tion becomes focused on relative shares and
conflict intensifies.
A program to minimize this conflict should
have three interrelated articles:
I. Increasing productive capacity.
II. Slowing inflation.
III. Spending more for the disadvantaged.
This program would meet, respectively, the
major concerns of upper-, middle-, and lowerincome groups and form the compact among
them.

ARTICLE I:
CAPACITY

IN C R E A S IN G

and there is no reason to believe we know any
better how to do the job now.
Another way to encourage an increase in
capacity would be to manipulate interest rates.
The importance of interest rates in business­
men's decisions to increase capacity has long
been debated, but it is clear that low rates
would make attractive some projects that are
not profitable at high rates. Unfortunately,
deliberate attempts to force interest rates down
would also aggravate inflation. This would in­
evitably mean flooding the econom y with
money that would eventually serve to bid up
prices— including interest rates themselves.
The key to boosting productive capacity, in
my opinion, is to make it profitable to do so by
bringing down inflation. As matters now stand,
something between a third and a half of today's
record-high (long-term) interest rates constitutes
the investor's hedge against inflation, a device
for protecting himself against the fact that his
interest receipts will be in cheaper dollars. Once
the investor becomes convinced that inflation is
no longer inevitable, he will be content with
lower interest rates. Reduction in the inflation
component of interest rates is not likely to stimu­
late increased capacity by itself. But the winding
down of inflation is likely to increase investors'
confidence in the stability of the economy. This
confidence produces a further reduction in the
return investors require on their funds and, in
turn, will make it more profitable for producers
to expand capacity.
Reducing inflation, however, will take time. It
might be helpful if we can induce businessmen
to maintain, if not enlarge, capacity during the
interim. One key to doing so is corporate profits.
When corporations enjoy strong profit perfor­
mance they can plow earnings back into plant
and equipment and raise capital in the securities
market. Corporate profits (before taxes) relative
to replacement costs have trended downward in
the past two decades. This trend was reversed
briefly during the early '60s but resumed again in
the latter '60s and reached a low in 1970. An
improvement in this trend could help probably
more than anything else to encourage an in­
crease in capacity.

PR O D U C T IV E

Some business analysts are projecting that
over the next 10 to 15 years funds will have to be
poured into plant and equipment at a rate at least
one-and-a-half times the rate of the last dozen or
so years just to maintain real economic growth at
its historical average— about 4 percent. Needs
for larger capacity in a numberof basic industries
are apparent from current shortages, even at a
time of sluggish growth. Needs for increased
capacity to produce public and social services—
urban transportation, low-income housing, im­
provement of the environment, and the like—
have been obvious for years.
But there is a very real question of just how to
boost our ability to produce. One method cur­
rently proposed for increasing productive capac­
ity is to divert the flow of credit from “ non­
p roductive" to “ prod uctive" uses. I don't
believe this would work because I doubt that any
government official can determine which uses
are productive and which are not. Past attempts
to do so have not been particularly successful




4

FEDERAL RESERVE BANK OF PHILADELPHIA
inflation by encouraging expansion in capacity
and, hence, output.
This article of the compact should have a great
deal of appeal for businessmen and upperincome groups. It might be greeted with less than
enthusiasm by those in the middle-income group
because it means a shift in emphasis from con­
sumers' goods to producers' goods— from cars,
TVs, and houses to factories and machine tools.
It is the individual in the middle-income group
who buys most of these consumer goods in our
economy. He is unlikely,to be turned on by a
vague need to increase industrial capacity. There
must be something in the compact meaningful
for him.

A better measure of the ability of corporations
to raise investment funds (which includes profit
performance) is the market value of their se­
curities relative to replacement costs for capital
goods. W hen the price they can get by floating
new securities rises relative to the cost of replac­
ing their plant and equipment, it is easier to
finance increased capacity. Between 1951 and
1965 corporations were able to finance their
investment plans with increasing ease. This trend
was reversed in the mid-'60s, however, and cor­
porations found the securities market an increas­
ingly costly place to finance capital expendi­
tures. An increase in stock prices, a reduction in
interest rates, and a slowdown in rising prices of
capital equipment could turn the situation
around. All could come from a lessening of infla­
tion.
Many things are responsible for this situation,
but government can help mitigate it. As a start,
making the effective tax rate more impervious to
inflation might be desirable. For example, basing
capital depreciation allowances on the current
costs of replacing capital equipment, rather than
historical costs, would help in eliminating the
upward lift that inflation gives to corporate in­
come tax rates. Another step along these lines
would be to modify tax rates on increases in the
value of corporations' inventories owing merely
to inflation. This too would help to keep corpo­
rate taxes more in line with true corporate in­
come during inflationary episodes.* Congress
should continue its exploration of other possible
changes in capital gains taxes to stimulate in­
vestment. O f course, fiscal measures such as
these must not be permitted to throw the budget
out of balance and thus frustrate anti-inflation
efforts. But within this constraint these measures
may be able to diminish the costs of reducing

ARTICLE II: SLO W IN G INFLATION
Economists know much less than they would
like about who benefits and who suffers from
unanticipated inflation. Recent analysis suggests
that those in the middle-income group may tend
to benefit compared with others as inflation ac­
celerates because they are relatively large debt­
ors. They are the ones who buy on installment
and those who owe most of the mortgage debt.
To the degree that higher prices do not get fully
built into interest rates, these debtors gain be­
cause they pay back their debt in cheaper dol­
lars.
Those in the middle-income tier, however,
appear to have suffered relatively on the earn ings
front. As inflation has accelerated, their income
has not kept pace with national income. There is
no question that inflation is uppermost in the
minds of the middle-income classes. Polls indi­
cate that they believe government is primarily
responsible for inflation so it is reasonable to
believe that they look to government for a solu­
tion.
Economists have talked for years about the
"m oney illusion" which deludes the unsophisti­
cated person into thinking his lot is improving
when all along he is being cheated by rising
prices. The reverse effect may well be at work
today. I believe that people in the middleincome category want inflation to end badly
enough to give up some consumption in order to
make it happen.

*Thesetwo aspects of corporate taxes played a measurable
role in pushing up the effective tax rate on true corporate
income from 37 percent in 1967 to 43 percent in 1972 to 49
percent last year. This compares to the downward slide in
corporate taxes from 48 percent in 1960 to 37 percent in
1967— a period also characterized by a marked increase in
the share of G N P going into investment as well as a sharply
rising rate of capital growth. Source: W illia m D. Nordhaus,
" T h e F allin g Share of Pro fits” , Brookings Papers on
Economic Activity, I, 1974, table 5, p. 180.




5

OCTOBER 1974

BUSINESS REVIEW

society. Such an improvement would tend to
reduce the incidences of unemployment among
this group.
All this, of course, would cost money and
would have to come out of the Federal budget. If
the budget is to remain at or near balance, as it
should to combat inflation, money for these so­
cial programs would have to come from some
other category. The biggest and most obvious
candidate is defense.
This third article of the compact can be the
basis for a meaningful social program which the
nation badly needs, but it must be sold as more
than this. It is a vital part of a total package
necessary to increase capacity to produce and to
control inflation. Together with the other two
articles it can enable the nation to weather a
difficult time ahead with a minimum of conflict.

In short, meaningful efforts to slow inflation
would likely satisfy the major concern of those
with middle incomes. It would be enough to
induce them to agree to the compact. But what
about those in the lower-income group?

ARTICLE III: MORE FOR THE D ISAD VAN­
TAGED
Although the recent increases in food and fuel
prices have hit them hard, the poor and
minorities generally do not suffer from inflation
as much as is commonly thought. Their main
nemesis is unemployment. And this presents a
problem. For if inflation can be conquered only
by slow growth of the economy, this inevitably
will mean higher unemployment. And, unfortu­
nately, when total unemployment rises, un­
employment among the disadvantaged rises
much more— hence, the need for the third article
of the compact.
The disadvantaged must be insulated from the
devastating effect of generalized unemploy­
ment. One whole category of policies would be
com pensatory. This category includes un­
employment compensation, income mainte­
nance, and government employment. These are
all to the good and should be used. Reform of the
welfare system or, preferably, its substitution by
some form of family income maintenance is
especially important. A program by which the
Federal Government would become a sort of
employer of last resort is also an idea that should
be tried.
All these efforts, however, are second best to
basic programs which would upgrade the com­
petitive position of the disadvantaged. These in­
clude training and education which would help
to make people more productive members of




COMPACT OR CONFLICT?
The second half of the 1970s could place
some additional burdens on all of us as
econom ic policymakers attempt to put the
economy in order. Policies to bring down in­
flation and curb its attendant inequities will play
a significant role in determining the size of the
burden and whether it is born equitably.
If economic policies do not work to produce a
fair sharing of this burden, increasing unrest and
conflict could result. If, however, an economic
compact is reached, whereby all individuals,
whether high-, middle-, or low-income, share
the load in an equitable fashion, the economic
strains of the last half of the decade should be
decreased. An econom ic strategy aimed at
boosting the ability to produce, bringing down
inflation, and aiding the disadvantaged should
provide the necessary ingredients for such a
compact.
S

6




Why Am eric a's
Cil Supply
Depends
. on
D ish -triced
Foreign Sources
By Vincent A. Gennaro

BUSINESS REVIEW




OCTOBER 1974

CHART 1

OVER THE LAST 25 YEARS, THE UNITED STATES HAS INCREASED
BOTH ITS DEMAND FOR ENERGY AND ITS DEPENDENCE ON
PETROLEUM AND NATURAL GAS AS ENERGY SOURCES . . .
Percent of Total Energy Consumption*

U. S. Energy Sources of Consumption
50

■S§3-1948

* Total energy consumption for 1948 and 1972 was equal to the energy
equivalent of 16.0 and 35.7 millions of barrels of oil per day respectively.
Source: John D. Paulus, “ The Outlook for Petroleum Prices and Supplies,”
prepared for the Committee on Business Analysis, Board of Gov­
ernors of the Federal Reserve System, 25 June 1974.

8

FEDERAL RESERVE BANK OF PHILADELPHIA

CHART 2

BUT DOMESTIC CRUDE OUTPUT, REFINERY CAPACITY, AND PRO­
DUCTION OF REFINED OIL HAVE LAGGED FAR BEHIND DOMESTIC
CONSUMPTION.
Millions of Barrels per Day
18
17
16
15
14
13
12
11
10

9

8
7
6

5

0
1950

1955

1960

1965

1970

* Includes natural gas liquids.
Source: John D. Paulus, “ The Outlook for Petroleum Prices and Supplies,”
prepared for the Committee on Business Analysis, Board of Gov­
ernors of the Federal Reserve System, 25 June 1974.




9

BUSINESS REVIEW




OCTOBER 1974

CHART 3
TH IS HAS RESULTED IN A GROWING DEPENDENCE ON IMPORTED
OIL . . .
Percent

10

FEDERAL RESERVE BANK OF PHILADELPHIA

CHART 4
MOST OF WHICH COMES FROM A CARTEL OF OIL-PRODUCING
NATIONS.
Percent
65

60

55

50

45

40
0
1970

1971

1972

1973

* OPEC countries include United Arab Emirates, Algeria, Ecuador, Indo­
nesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, and
Venezuela.
Source: U. S. Department of the Interior, Bureau of Mines.




11

BUSINESS REVIEW




OCTOBER 1974

CHART 5

THIS LEAVES LITTLE CHOICE IN THE SHORT RUN BUT TO PAY
RISING PRICES FOR CRUDE OIL IN WORLD MARKETS, RESULTING
IN HIGHER PRICES FOR HEATING OIL AND GASOLINE.
Cents per Gallon*

Dollars per Barrel

* Consumer prices.
Source: Morgan Guaranty Survey, May 1974.

12

Shortages:
A Necessary Evil
Of the Future?
By Donald L. Raiff

Their grocery carts colliding, two shoppers at
the local supermarket scramble for the last rol I of
paper towels. Across the street, a long line of
automobiles waits for gasoline. These and simi­
lar scenes have been publicized by the popular
press as examples of recent material shortages in
the U.S. economy.
To some people, today's “ shortages" portend
more empty shelves in the local markets as well
as depletion of “ necessary" raw materials. Yet,
Government price controls appear to have been
a fundamental cause of the product shortages.
Holding prices down encourages heavy demand
for goods and discourages suppliers from in­
creasing their output. Thus, current shortages
need not suggest continuing problems provided
the future is free of price controls.
But what about the chance that market forces




may fail us and that we will eventually run out of
a “ necessary" raw material? Although this
scenario is a possibility, econom ic analysis
suggests a more likely path— increases in the
prices of materials in short supply relative to
those that are not so scarce. The higher price of
the scarce commodities will then make it more
practical to conserve remaining supplies and
search out substitutes.
Some citizens may actual ly prefer shortages to
the price rises necessary to clear the market.
They want to allocate goods by nonprice
methods during normal times as well as for
periods of a national emergency to protect cer­
tain groups such as the poor. However, in these
instances, a better solution would be to have the
Federal Government provide the poor with incorrie through direct transfers, while allowing
13

OCTOBER 1974

BUSINESS REVIEW
price movements to provide incentives for con­
serving resources and allocating available com­
modities.

creased supply or increased demand promise a
shortage. Thus, the Federal Government turned
the initial scarcity into a shortage by preventing
price rises to the consumer.
When studying shortages an economist zeroes
in on prices. In his view, there's a situation of
excess demand— a shortage— when at the cur­
rent market price consumers demand more of a
product than the market can immediately sup­
ply. If there is a shortage at this price, economic
theory holds thatthe market price will eventually
move upward to a level that eliminates the
shortage (see Box 1). The shortage will vanish as
higher prices cause buyers to review their spend­
ing plans and cut back on those items becoming
relatively more expensive. Also, profit-motivated
suppliers will find the higher prices an incentive
to increase the amount they bring to market.

SHORTAGES: THE NATURE OF THE BEAST
Perplexed Charlie Consumer asks: "H o w can
anyone blame the Government for the product
shortages? Our gasoline shortage resulted when
OAPEC (Organization of Arab Petroleum Ex­
porting Countries) tried to slap an embargo on
oil shipments to America. So, the Arab exporters
were the culprits, weren't they?"
O APEC members played a key role in orig­
inally decreasing the quantity of oil brought
to the U.S. market and causing the initial scarci­
ty. Yet, neither smaller supplies nor larger de­
mands by themselves imply shortages. Only if
prices are unable to move upward w ill de­

BOX 1

WHAT ABOUT LOCALIZED ONE-TIME SHORTAGES?
The product shortages referred to in the text of this article are those experienced across
regions in the U.S. by large numbers of firms or large numbers of consumers over a long period.
Other localized shortages occur occasionally because of one-shot breakdowns in the distribu­
tion process, an inability to anticipate consumer demand over short periods, and/or an unwill­
ingness to vary certain prices daily.
If a bread truck breaks down so that its normal Monday store deliveries can't be made until
Wednesday, shoppers will most likely find a shortage of bread. Prices will probably not be
raised on Monday to allocate the available bread because the grocer would be accused of
taking advantage of a bad situation— windfall profits. Unless the supply, for at least this Mon­
day and Tuesday, responded to higher prices, the grocer would probably plead for continued
goodwill for himself and bad feelings for his supplier, while leaving prices unchanged.
Attending a theater for the opening of a highly publicized movie may provide another
example of a local shortage— theater seats. W h y shouldn't the theater manager raise the
admission to discourage some of the demanders, save the long lines, and eliminate the un­
certainty of such an admission policy based on queues? A number of reasons enter the man­
ager's judgment to change his pricing policy. How would he get this information out to his
potential market? Since the demand may differ between the 7 and 10 o'clock shows, he would
have to vary his price to attract just enough people to "fill the house." For the sake of simplicity
and goodwill, he may decide to keep the price unchanged and allocate by way of long lines. In
this way any disappointment of a potential movie-goer is usually voiced against the people
ahead of him in line rather than the price setter— the theater manager.




14

FEDERAL RESERVE BANK OF PHILADELPHIA
Would there necessarily be a shortage if a
large number of suppliers suddenly withheld
their product from the market? No. If prices were
allowed to move upward, this would allocate the
available items as well as provide suppliers in­
centive to stop their withholding action. Thus,
newsmen observing the situation would report
rising prices, but no lengthening of the waiting
lines or shrinking inventories of goods.
"Everyone seems to be able to obtain the amount
they desire to purchase" would be the report
because the "symptoms" of shortages would not
be evident to the newsmen.1
Arguments that rising prices will not eliminate
the shortages imply that consumers and produc­
ers make decisions independent of the price
level. However, as long as either the supply or
demand is even slightly responsive to price
changes, a price increase will eventually elimi­
nate the shortage.2 The price will rise to a
market-clearing level— the level which will spur

producers to supply exactly the quantity de­
manded by customers. It is true that the size of
the hike necessary to clear the market hinges
on the market participants' sensitivity to price
changes.

PRICE CONTROLS IN A CHANGING
ECONOMY INSURE SHORTAGES
The demands of both domestic and foreign
consumers, as well as the supply intentions of
firms and labor, can change— sometimes rapid­
ly. Increases in demand and/or decreases in
supply will raise the level of the market-clear­
ing price. If Government controls hamper the
free movement of market prices, these prices are
prevented from doing their double duty— ration­
ing the available commodity among competing
shoppers and providing the necessary incentive
for businessmen to expand their output. Without
the assistance of upward price movements,
demanders will not be able to find adequate
supplies of the products they desire. Nonprice
rationing schemes such as queues and, in some
instances, black markets w ill spring up to
allocate the available commodities. Suppliers
may even attempt to cut costs by changing the
product (see Box 2).

'Rising prices should not be called a symptom of short­
ages but rather the normal market adjustment to a de­
crease in supply or increase in demand. The main shortage
symptom is when consumers are unable to obtain the
amount they are actively trying to purchase.
2
The precise process w hich generates the rise in the market
price is probably a combination of unsatisfied demanders
offering higher prices and suppliers raisingtheir selling prices
as they notice the unsatisfied demand.

Changing Demands Alter Market-Clearing
Prices . . . The idea that the amount demanded of
most goods will rise as the price of that product

BOX 2

CONTROLS GERMINATE A NEW ALLOCATION DEVICE
AND PRODUCT ALTERATIONS
On August 15, 1971, the U.S. Government dramatically enlarged its efforts to control
reported market prices (wages are the price for labor services).* This price control effort
clamped ceilings on many of the prices of items sold in the United States. Some of the ceiling
prices changed as the Federal effort moved through its various phases. But the relevant question
is whether the official ceiling was below the price which would have equated the quantity
supplied with the quantity demanded— the market-clearing price. If so, the quantity must be
allocated through a non price method (such as— first come, first serve), and/or suppliers may cut
costs by altering the product.




C o ntinu ed on next page

15

BUSINESS REVIEW

OCTOBER 1974

Box 2 (Continued)
For illustrative purposes, consider the most recent example of price ceilings in the face of a
large decrease in supply— the automobile fuel market, during the first quarter 1974. Evidently
the quantity brought to the coastal markets by the suppliers was neither as great as that sold in
similar periods a year before nor as great as the contemporary quantity demanded, given the
posted prices. During this period posted prices were allowed to rise a few cents— as the Cost of
Living Council and then the Federal Energy Office allowed increases in crude oil costs to be
passed along. But this allowable price increase did not consider the effect of a decreased
quantity brought to market and the price rises necessary to induce users to buy a reduced
amount. Consequently, customers experienced rationing by other methods such as queuing,
maximum purchase sizes, and sales only on alternative days depending on the odd or even
number on the license plate.
Besides the nonprice allocation schemes, the purchased product changed. Before the
oil embargo last year, gasoline was sold as a "joint product" with the services of windshield
cleaning and a check under the hood "with a smile." In addition, sellers vied to make sure the
consumer had a 24-hour daily option on such purchases. With Federal orders controlling the
pump price, sellers profited only by curtailing costs and thus the services supplied. The result
was shorter hours (7 A.M. to 10 A.M. was frequent in the Philadelphia area) and less frequent
delivery of the ancillary services accompanied by attendants' smiles.
*Before 1971, the U.S. Governm ent has regulated prices for such products as electricity, telephone services, and
even a bank's depository services.

falls and vice versa is a familiar one. However,
there can also be an "increase in demand" for
the product. This increase in demand means that
consumers want even more of the commodity at
the current price than they wanted previously.
They are also willing to pay more for the same
amount of the product than they would have
earlier. For example, what would happen within
a community if each person receives an unex­
pected $5,000 tax rebate? Suppose also there
exists in this community a small combination
manufacturing and retail business for mahogany
furniture called Ethan's Place. This firm's hand­
crafted Early American line is the "luxury" many
residents want to buy with their new-found
dollars. Before receiving the rebate, they just
couldn't afford the purchase, but now many
more can. This increase in demand for furniture
will be recognized first in the retail outlet, as
floor samples are sold in an attempt to satisfy the
growing number of back orders. The owner's




natural response would be to increase produc­
tion, but the manufacturing plant is already
operating with a full shift of workers. To expand
output, Mr. Ethan must pay his laborers time and
a half for overtime, and this will increase costs
per unit of furniture. If the firm is to expand out­
put to meet the increased demand, it must charge
a higher price to cover these rising per-unit costs
and maintain profits. A general premise for any
firm is that unless output can be expanded with­
out increasing per-unit costs, increased demand
will force prices upward until the market is
cleared with increased output.3
*

3 ve r long periods, firms can adjust their production
O
technology and possibly lower the per-unit costs of produc­
tion and even new firms may enter the industry. But not all
industries have technological breakthroughs or gain large
economies by increasing the number and size of firms.
Those without such breaks rely on increased prices to justify
increased production.

16

FEDERAL RESERVE BANK OF PHILADELPHIA

. . . But Movements Are Stymied by Price
Controls. If prices are fixed by Government fiat,
the market response would be stymied. The
owner of the furniture-manufacturing outlet will
spot the increased demand in the same way— in­
creased orders and lower inventories. But, if his
per-unit costs rise with any increase in the quan­
tity brought to market, he will not increase the
amount supplied because doing so is unprofit­
able. He cannot recover higher unit costs by
raising prices because of Government price con­
trols. The result is a shortage of this Early Ameri­
can furniture, and an upsurge in cocktail party
inquiries as to why Mr. Ethan doesn't increase
production and eliminate the shortage.
The U.S. natural gas industry is a good exam­
ple of the actual problems caused by price con­
trols during a period of rising demand. The
agreement to fix prices at the wellhead goes back
to 1954— a time when natural gas was plentiful
at the market price.4 As possible uses of the
product were expanded, demand increased
yet prices were held down by the Federal
Power Commission, at least relative to other
fuels. The accelerating popularity of natural gas
and its accompanying scarcity seems to stem
from the U.S. Government's effort to hold down
the price of natural gas. The low price spurred
demand but failed to provide sufficient incentive
to increase production.
W h ile the price of natural gas rose 20 percent
between 1950 and 1970, that of coal soared 80
percent, and that of heating fuel jumped 33 per­
cent. In 1972 the cost of heating a home with gas
in U.S. averaged 29 percent less than heating by
fuel oil and 52 percent less than the cost of
heating by electricity. As a result, consumers are
now using natural gas faster than reserves are
being discovered, natural gas inventories are de­
clining, and in some areas new hookups are not

being accepted. Prior to 1969, the annual addi­
tion of new reserves of gas exceeded production
in the United States. But from 1968 to 1972, the
annual addition of new gas reserves averaged
only 47 percent of the production from existing
reserves. In 1973, reserves totaled only 270 trill­
ion cubic feet— a 12-year supply at current use
levels.
Although there has been a steady decline in
the production of existing gas reserves, an esti­
mate for "potential" natural gas supplies (that is,
gas not yet in proved reserves, but either iden­
tified or predictable according to acceptable
geological knowledge) in the United States as of
December 1972 is 1,146 trillion cubic feet. The
significance of these "potential" natural gas
supplies becomes apparent when it is under­
stood that 1,146 trillion cubic feet is more than
49 times America's consumption in 1973. Thus,
the natural gas shortage resulted not from an
inadequate domestic resource base, but from the
lack of an economic incentive to remove gas
from the ground because of controlled wellhead
prices.5

Supply Changes Can Alter the Market-Clear­
ing Prices. . . Other forces that can alter the
market-clearing price are changes in supply. If
demanders' plans are unchanged, a "decrease in
supply" will force a rise in the clearing price.
This decrease in supply means that suppliers
reduce their output at current prices. Similarly,
they must get a higher price for their goods to
maintain their original level of output. For ex­
ample, what happens in the furniture town re­
ferred to earlier if there's no tax rebate, but
rather the suppliers of mahogany are able to
conspire and double their price for the wood
needed in Mr. Ethan's manufacturing prices?
Now, his per-unit costs increase across the board
regardless of his level of output. Recognizing
the need to pass along this input-cost rise to

4ln 1938 Congress passed the Natural Gas Act for the
purposes of placing pipelines selling natural gas in interstate
com m erce under the regulatory authority of the Federal
Pow er Commission. The act was specifically made inapplic­
able " to the production or gathering of natural gas." Sales of
gas at the wellhead by independent producers thus con­
tinued unregulated by the FPC until the 1954 Supreme Court
decision in Phillips Petroleum Co. v. Wisconsin.




5See “ Toward an Adequate Natural Gas Supply" pub­
lished by the Gas Supply Committee, 1725 DeSales Street,
N .W ., Washington, D.C., September 1973, Sections ll-lll;
and "Federal O il and Corporation Gas Proposals," Legis­
lative Analysis No. 18 (Washington: American Enterprise
Institute for Public Policy Research, 1974).

17

OCTOBER 1974

BUSINESS REVIEW

able at home. The difference must be wide
enough to cover differential shipping and mar­
keting costs between the two markets. Suppose
that for some reason— increases in demand or
decreases in supply— the world price of a prod­
uct increased. In the domestic market, effective
Government intervention may keep the U.S.
price from rising. However, it cannot keep the
world price from rising relative to the prevailing
U.S. price. If the spread between the domestic
price and the value of the item in the foreign
markets becomes wide enough to cover exporta­
tion costs, the American firm may find it more
profitable to sell to foreigners abroad rather than
to purchasers at home, as the latter are limited in
the price they can offer. This situation will swell
exports and probably shrink domestic supplies
for all products affected.
The aluminum industry illustrates this point.
Aluminum will be facing a severe "capacity
crunch" during the next several years. The be­
ginnings of a tight supply situation can be fol­
lowed through two periods. First, the industry's
profitability declined during the sluggish period
of demand at the beginning of the 1970s. Sec­
ond, during the subsequent period of booming
sales, the industry failed to attain a return on
investment large enough to justify the new
facilities required to meet the projected demand
of the mid-decade. It is the latter period where
price controls played a role.
Domestic and foreign demand for aluminum
recovered sharply in 1972, and the supply situa­
tion became very tight in 1973. With supplies
tightening, the selling price for ingot aluminum
in the spring o f '73 finally reached the published
price of 25 cents per pound, ending more than
three years of selling at a price discounted below
the list price. Continued price recovery was
thwarted by the establishment of a 25-cent ceil­
ing price under Phase IV. Under the program,
further increases were to be limited only to those
necessary to cover cost increases incurred dur­
ing 1973.
During the last half of 1973, as the foreign
price climbed to 42 cents per pound, the United
States became a net exporter of aluminum for
the first time since 1970. In December the Cost

maintain his profits, he quickly decides that only
a price increase can keep him in business. The
level of demand for the furniture has not
changed; therefore, some people considering
future purchases will be discouraged by the
higher price and buy something else instead,
thus decreasing final output.

... But Movements Are Stymied by Price Con­
trols. If posted prices are fixed by Government
fiat, the market response is blocked. The supplier
recognizes the need to increase prices in the
same w ay— his cost of raw mahogany has in­
creased. With the option of raising prices sealed
off, he exercises other options which may in­
volve cutting unit costs even to the extent of
lowering product quality or changing its design.
If he cannot discover a way to attain an accept­
able rate of return over the longerhaul, he will go
out of business.
Beef is a good example of an industry that
experienced supply shifts while under Federal
price controls in 1973. As cattle feed prices rose
throughout 1973, suppliers attempted to pass
on their cost increases through slaughtering,
packaging, and retail sales to the consumer.
Some shoppers switched to less-expensive foods
and bought less beef. However, cattlemen were
generally able to pass along their cost increases
until meat prices were frozen in late March (con­
tinuing through September 10). The meat indus­
try, faced with a lid on retail prices and few quick
cost-cutting measures, essentially shut down the
slaughtering and packaging of production.
Some retailers, to stay in business, sold beef at
a loss while attempting to make their profit on
other products carried in their markets. H ow ­
ever, in general, sparsely filled meat counters
were the order of the day, despite the continued
relative abundance of cattle.

Problems in Domestic Markets for Products
Traded Internationally. A ceiling price will also
produce shortages when there are two markets
for a single product— one controlled, the other
uncontrolled.
Consider the United States's domestic and ex­
port markets. Firms export if the price they can
obtain in foreign markets exceeds that obtain­




18

FEDERAL RESERVE BANK OF PHILADELPHIA
of Living Council permitted a 16-percent in­
crease— from 25 to 29 cents per pound— in the
base price of prim ary ingot. The C ouncil
acknowledged that the action was necessary to
encourage the expansion of domestic capacity
and reduce the differential between foreign and
domestic prices. In short, the Council moved to
let the aluminum price rise to alleviate domestic
shortages.

serve it.6 In a sense, the company can save by
holding stores of this commodity ratherthan dol­
lars. As long as the expected rate of growth in the
value of this commodity exceeds the interest rate
plus any costs of holding this resource, the com­
modity is worth more undeveloped than de­
veloped. Under these conditions, if the owner
develops the resource, sells it, and buys invest­
ment securities at the existing rate of interest, he
will have less money than if he waits a year
before developing and selling it. As such then,
the market-clearing price and expectations
about its movement can stimulate conservation
as well as more rapid development of resources,
depending on the direction of expected move­
ments. This scenario also highlights the impor­
tance of the level of the interest rate in determin­
ing the conservation of raw materials— and it
suggests a potential danger in regulating interest
rates over any long period.7

THE FUTURE IN TERMS OF EXHAUSTIBLE
RAW MATERIALS
It might appear that some necessary resources
are going to be exhausted, given our current
rate of consumption. But in a com petitive
market the incentives would more likely insure
the development of substitutes or conservation
of presently available resources. If the demand
for nonreproducable resources increases— as is
being generally forecast— the market-clearing
price for the resources will very likely increase.
Price appreciation of scarce resources will
feed back on the production costs of final prod­
ucts using such material. A rising price of one
final product relative to another gives consumers
an incentive to cut back on their use of the good
becoming more expensive. Producers of the
good becoming relatively dear may then find
it more profitable to develop new production
technology using substitute raw materials.
Suppliers of raw materials that are becoming
more expensive have the incentive to search for
and develop additional sources of these mate­
rials. It is possible that some locations—
identified by geologists but previously too costly
to work— will now be tapped because the higher
price makes them profitable (see Box 3). The
d evelop m en t effort may also generate
technological breakthoughs in the process of
mining the raw material and even in geological
efforts to discover the location of resource de­
posits.
Private ownership is important to the conser­
vation of resources. Suppose a firm has private
rights to land containing some raw material; ex­
pectations that the price of that resource will rise
rapidly in the future provide an incentive to con­




THE CLAMOR FOR GOVERNMENT ACTION
What about the poor? Some people favor price
controls— regardless of the shortages caused—
because they claim that the poor are "unfairly"
squeezed out in the distribution of commodities
by "high prices." Others might argue that con­
trols would be necessary in times of natural dis­
asters to insure distribution of goods to the af­
fected parties. Still others would point to their
need during wartime to insure the allocation of

6Establishing ownership is an important ingredient in find­
ing the best method and level of conservation for our raw
materials. It is not the fact that a resource has econom ic value
that leads to its depletion, but more important how it is
owned. For example, fish and beefsteak both have econom ic
value, but the stock of N ew England coastal fish is being
depleted w h ile cattle survive. The fish are ow ned by
“ everyone," w h ile cattle are owned by individuals (or agents
of the individuals) w ho have the right to keep others from
slaughtering them. Hence, they can capture the value at
some time in the future, which cannot be assured under
common ownership.
7 some this may seem a far-out connection between the
To
financial markets and conservation of resources, but as long
as financial securities are alternative investments to holding
real assets the connection exists.

19

BUSINESS REVIEW

OCTOBER 1974

BOX 3

PROJECTING RESOURCE DEMAND AND RESERVES
Since World W ar II, a number of technical studies have made projections about future
resource usage and attempted to quantify the amount of raw materials available in the United
States and the world.* In doing this, the analysts have had to forecast and incorporate the effects
of growth, technological innovations, and changes in consumer preferences. These forces of
change will alter the market-clearing price of a resource relative to its substitutes. It is this
relative price which is crucial to the production and consumption decisions made everyday.
Taking present studies as the starting point, it might be useful to examine how they project
future demand and arrive at a concept of reserves. As an example, consider the 1973 report
compiled by the National Commission on Materials Policy. The demand until the year 2000 is
estimated to repeat the growth experienced from 1950 through 1970. The cumulative demand
1971-2000 is calculated by adding up the consumption in each year. This technique ignores
the effects of new movements in relative prices simply because these shifts were judged too
difficult to estimate; as such, this is reason to doubt the accuracy of the estimated demand.
To set a framework for discussion of nonreproducable raw material supplies, the study
defines the amount listed as reserves as that quantity known to be available using processes less
costly than the current open market price. These reserves are available without any new price
changes or technological breakthroughs. However, there are some quantities, call them
identified resources, which are essentially well known as to location, extent, and grade, buttoo
costly to mine presently.Presumably these resources will be exploitable in the future under
changed economic conditions or with improvements in technology. For each commodity,
there may be a third classification of quantities undiscovered but predictable according to
accepted geological knowledge. Call this third group hypothetical resources.
To understand some of the implications of these data, assume there exists some hypothetical
commodity, RAMAT. This hypothetical material is typical of those commodities whose
cumulative demand projection substantially exceeds their current reserves, say the average of
those in the Table. This average ratio of probable cumulative demand to reserves of these
resources is 5.2. At first glance, we would expect to run out of RAMAT before the end of the
current decade. However, as the reserves are used up, suppliers will find themselves able to
raise prices to allocate dwindling supplies over future years. As the open market price of
RAMAT rises, demanders will cut back on their quantity demanded and suppliers will find it in
their interests to bring forth some of the identified resources and even to explore more of the
hypothesized resources. Depending on the size of the identified reserves, their costs of recov­
ery and the findings from further exploration, a shortage at 1971 prices could turn into abun­
dance at 1980 prices.

See the following resource comparisons with expected consumption in J. Frederic Dewhurst and Associates

Americas Needs and Resources. Twentieth Century Fund Report 1947; Resources for Freedom, Report of the
President s Materials Policy Commision (Washington: Governm ent Printing Office, 1952); Hans H Landsberg et al
Resources m America's Future (Baltimore: Johns Hopkins Press, 1963); Material Needs and the Environment Today
and Tomorrow, Final Report of the National Commission on Materials Policy (Washington: Governm ent Printing
Ottice, 1973).




°

20

FEDERAL RESERVE BANK OF PHILADELPHIA

RESERVES AT CURRENT PRICES DO NOT TELL THE WHOLE STORY
(A)

(B)

Aluminum
Antimony
Asbestos
Barium
Beryllium
Boron
Bromine
Copper
Feldspar
Fluorine
Gold
Gypsum
Iodine
Iron
Lead
Lithium
Mercury
Molybdenum
Natural Gas
Petroleum
Phosphorus
Planinum
Potassium
Silver
Sulfur
Talc
Tungsten
Uranium
Zinc

(D )

(C/D )

(E)

(F)

U n its1

Com m od ity

(C)
Probable
Cum ulative
Dem and
19 7 1 -2 0 0 0 2

U.S.
Reserves
at 1971
Prices2

Dem and
Relative
to
Reserves

Identified
Resources

H ypothetical
Resources

370
822
43
31
28
5
12
93
38
39
293
726
269
3
34
183
1,730
3
1,098
276
208
16
216
4,400
514
52
1,000
1,240
62

13
110
9
45
28
40
17
81
500
6
82
350
225
2
17
2,767
75
6
279
38
39
1
50
1,300
75
150
175
130
30

28.5
7.5
4.8
.7
1.0
.1
.7
1.1
.08
6.5
3.6
2.1
1.2
1.5
2.0
.07
23.1
.5
3.9
7.3
5.3
16.0
4.3
3.4
6.9
.3
5.7
9.5
2.0

Very Large
Small
Small
Very Large
Very Large
Very Large
Fluge
Large
Fluge
Small
Large
Huge
Very Large
Very Large
Large
Huge
Small
Huge
Moderate
Large
Very Large
Moderate
Very Large
Moderate
Huge
Very Large
Moderate
Large
Very Large

KDI3
Small
Insignificant
Very Large
Huge
Huge
Huge
Large
Huge
Small
KDI3
Huge
Huge
Huge
Moderate
Huge
KDI3
Huge
Large
Large
Huge
Large
Huge
Large
Huge
Huge
Moderate
Large
Very Large

Million S. T.
Thousand S. T.
Million S. T.
Million S. T.
Thousand S. T.
Million S. T.
Billion lb.
Million S. T.
Million L. T.
Million S. T.
Million tr. oz.
Million S. T.
Million lb.
Billion S. T.
Million S. T.
Thousand S. T.
Thousand flasks
Billion lb.
Trillion cu. ft.
Billion bbls.
Million S. T.
Million tr. oz.
Million S. T.
Million tr. oz.
Million L. T.
Million S. T.
Million lb.
Thousand S. T.
Million S. T.

’S. T. = Short Tons, L. T. = Long Tons, lb. = pounds, tr. 02 . = troy ounces, kg. = kilograms, bbls. = 42 gals.
2 estimated by U. S. Bureau of Mines, 1973.
As
3
Known data insufficient.
Source: Material Needs and the Environment: Today and Tomorrow. Final Report of the National Commission on Materials Policy
(Wasington: Government Printing Office, 1973), pp. 4B-8 to 4B-9.




21

OCTOBER 1974

BUSINESS REVIEW

profit incentive.1
0
During wartime every citizen is supposed to
pay the price of victory through the personal
sacrifices asked by government. However, it
would be wise for government to avoid institu­
tions which are inefficient and hinder the incen­
tives to increase productivity and conserve in
consumption. Price controls are such an institu­
tion. It would be better for government to bid
away from other uses the resources needed to
win the war. The resulting increases in income to
suppliers of equipment (and manpower) would
provide incentives for them to heighten their
efforts. Rising prices for material and labor
would also encourage conservation of resources
in nonwar endeavors. If any changes in the re­
sulting distribution of income were desirable,
this could be handled through income taxes.

resources to the national effort and not some
profitable venture which appears not to assist in
winning the war.
It is true that prices discriminate according
to the ability to pay. Not that the rich will con­
sume all commodities, but with their superior
ability to pay they will probably end up with
more of the available goods and services. If soci­
ety wants to change this distribution, there are
more efficient methods than Federal price con­
trols. First, it is not clear that the poor will be
better off in the longer run when a nonprice
allocation scheme is substituted for price rises.8
Second, price controls shrink the size of the total
"p ie " of goods and services available by ham­
stringing the incentive necessary to increase
output by suppliers.9 An "unsatisfactory" dis­
tribution of income could be better solved by
using government as a vehicle to tax the nonpoor
and give income to the poor through transfer
payments. This w ou ld save the efficient
product-allocation scheme and allow society to
see more explicitly the costs of accomplishing
this social goal.
During times of natural disasters, people may
be more willing to sacrifice personal wealth to
the common good of helping those caught in the
disaster. Thus, a democratic government might
be used as a vehicle to marshal the personal
resources of the "unaffected" and distribute
them to the "affected." However, attempts to
hold down prices forthe benefit of those less able
to pay will encourage everyone to consume
more of available goods. Also the incentive to
produce more— usually desirable at such times
— will be stifled as low prices hold down the

NECESSARY EVIL? NOT UNLESS PRICES ARE
STRIPPED OF THEIR POW ER
The future of shortages depends largely on the
application of price controls. Calls for such con­
trols depend on the citizenry and their under­
standing of the costs and benefits of such actions.
Fortunately, continued regulation of prices by
government fiat is not a certainty. When forced
to choose between shortages and price rises, it is
not clear that the consumer will choose the
former. Some shoppers would prefer to pay 60
cents for a gallon of gasoline rather than not
being able to buy gas if the price were set at 35
cents per gallon.
Relative prices— the price of one good as
compared to all other goods— are a powerful
tool in the markets' attempts to balance future
demand and future supplies as well as current
quantities. As such, they generate incentives that
affect production of desirable goods and the

8For a discussion of this in terms of rental housing, see
Howard Keen, Jr. and Donald L. Raiff, “ Rent Controls:
Panacea, Placebo, or Problem C hild?” Business Review of
the Federal Reserve Bank of Philadelphia, January 1974, pp.
3-11.

10For a reconstruction of the housing market after the San
Francisco earthquake of 1906 and discussion of the neces­
sary role of prices in such markets, see Milton Friedman
and G eorge J. Stigler, Roofs or Ceilings ? The Current
Housing Problem (Irvington-on-Hudson, N .Y.: Foundation
for Econom ic Education, 1946).

9
The goal could be just the opposite— enlarging the out­
put available for distribution. Investment in productive edu­
cation and machinery enlarges the econom y's ability to
produce and for this reason some people are urging govern­
ment to provide investment tax credits.




22

FEDERAL RESERVE BANK OF PHILADELPHIA
conservation of scarce resources. It would be
better to harness these motives to help ac­
complish social objectives than ignore their exis­

tence and appear indignant when they throttle
well-intentioned efforts by government.

s

N O W AVAILABLE:
INDEX TO FEDERAL RESERVE BANK REVIEWS
Articles which have appeared in the reviews of the 12 Federal Reserve Banks have been
indexed by subject by Doris F. Zimmermann, Librarian of the Federal Reserve Bank of Phil­
adelphia. The index covers the years 1950 through 1972 and is available upon request from the
Department of Public Services, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsyl­
vania 19101.




23

FEDERAL RESERVE BANK of PHILADELPHIA
PHILADELPHIA, PENNSYLVANIA 19105

business review
FEDERAL RESERVE BANK
OF PHILADELPHIA
PHILADELPHIA, PA. 19105