The Energy Crisis

Beginning in 1973, the Organization of Petroleum Exporting Countries (OPEC), which at that time controlled a substantial share of the world oil market, began to flex its muscles. Particularly disruptive was the oil embargo that followed the 1973 Arab-Israeli War. In response, the United States adopted price controls to protect consumers from the price increases. The result, as many economists predicted, was long lines at gas pumps: rationing by waiting time rather than by price.

This experience touched off a debate about how to meet the “energy crisis:” Should it be through government or through the market? Inevitably, both paths were followed. The Federal Energy Administration was established in 1974 (mainly through the merger of a number of existing agencies), and a cabinet level Department of Energy followed in 1977. Spending on a wide range of federal energy projects was increased. But in the end, much of the painful adjustment was the response to higher prices. Americans cut their energy consumption by buying smaller cars (many of them from foreign producers), insulating their homes, and investing in more fuel-efficient productive processes. On the supply side, higher prices produced a rapid increase in oil production in countries outside of OPEC, undermining OPEC’s monopoly power.

Source: Statistical Abstract of the United States, 2012, table 927.

The dimensions of the energy crisis can be seen in the data in Table 29.2. The first column shows what happened to the price of crude oil. As you can see, it rose dramatically and by 1980 was 6.76 times as high as it had been in 1970. The real price of oil (the price of oil divided by average prices), shown in the second column, also rose substantially, although not as much. A second oil price shock hit at the turn of the century. Between 2000 and 2008 the real price of oil rose by a factor of 2.9. The oil price shocks created incentives to use less and to substitute less costly forms of energy for oil. The result is shown in the last two columns of Table 29.2. The share of energy from petroleum in total energy fell from 45 percent in 1970 to 37 percent in 2010. And the amount of energy used to produce a dollar of GDP fell from 18 thousand BTUs in 1970 to a bit more than eight in 2010. Although reducing energy use created a number of benefits for the economy, including reducing the damage caused to the environment by economic activity, making these adjustments also took their toll. Savings that might have financed investments that increased output were used instead to finance investments that conserved energy or developed alternative sources. The energy crisis is a classic illustration of Economic Reasoning Propositions 2, choices involve trade-offs, and 3, incentives matter (see page 9).