DP6142 The Allocative Cost of Price Ceilings: Lessons to be Learned from the US Residential Market for Natural Gas

Author(s): Lucas W Davis, Lutz Kilian
Publication Date: February 2007
Keyword(s): allocative cost, deadweight loss, natural gas, price ceiling, regulation
JEL(s): D45, L51, L71
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6142

Following a Supreme Court decision in 1954, natural gas markets in the U.S. were subject to 35 years of intensive federal regulation. Several studies have measured the deadweight loss from the price ceilings that were imposed during this period. This paper concentrates on an additional component of welfare loss that is rarely discussed. In particular, when there is excess demand for a good such as natural gas for which secondary markets do not exist, an additional welfare loss occurs when the good is not allocated to the buyers who value it the most. We quantify the overall size of this allocative cost, its evolution during the post-war period, and its geographical distribution, and we highlight implications of our analysis for the regulation of other markets. Using a household-level, discrete-continuous model of natural gas demand we estimate that the allocative cost averaged $8.1 billion annually in the U.S. residential market for natural gas during 1950-2000, effectively doubling previous estimates of the total welfare losses from natural gas regulation. We find that these allocative costs were borne disproportionately by households in the Northeast, Midwest, and South Atlantic states. Costs were largest in New York, Pennsylvania, and Massachusetts with 70% of all costs borne by the ten states affected most.