Californians seem to have difficulty grasping the concept of a market when it comes to energy. I thought it might be useful to explain it in terms of something they understand. This fairy tale should help.

Once upon a time, there was a state called Texas. Like people everywhere in the modern world, Texans needed to go to the movies. They were very dependent on being able to see movies in movie theaters.

Although they loved watching movies, Texans hated movie studios. Environmentalists did not like the pollution that they caused. And nobody wanted movie production taking place in their neighborhood. So Texas tended to produce fewer movies than it consumed, and it had to import movies that were produced in a state called California.

For a long time, movie theaters were thought to be a natural monopoly, and ticket prices in Texas were fixed by a state regulatory commission. The commission set the price of movie tickets (the retail price) to be a markup over the prices that the theaters paid to the studios for the movies (the wholesale price).

The commission set the difference between retail price and wholesale price in such a way as to fix the rate of return on investment in movie theaters. The rate of return was guaranteed to be neither "too high" nor "too low."

With movie theaters given a guaranteed rate of return, there tended to be over-investment in movie theaters. Any time you have a guaranteed rate of return, you tend to have excess supply and some inefficiency. But this was not too bad an outcome--with excess supply the Texans never had to do without movies.

Then one day, the Texas government came up with an idea to get rid of the inefficiency. They would not guarantee the rate of return to movie theaters. They would let the movie theaters' profits fluctuate with the price of movies.

However, the Texas government decided to fix the price of movie tickets for consumers at $6, regardless of what the movie studios were charging the theaters. For a while this worked, because across the nation the demand for movies was not too high relative to the number of production studios and movie stars.

Unfortunately, the demand for movies kept growing, and the studios were able to charge higher and higher prices. In most states, which used the old "rate-of-return" regulation system, this caused the prices of movie tickets to rise to $8 to $10, as state commissions approved the increases in order to pass through costs.

In Texas, however, the price of movie tickets was kept at $6. While in other states people cut back on trips to the movies, Texans continued to flock to the theaters. But the theaters could not afford to pay the studios and charge only $6 for a ticket. When the theaters could no longer pay for movies, there were "blackouts" and theaters were dark.

Texans thought that it was extremely unfair that the terms of trade had shifted against them. In general, when the prices of goods that you consume (import) rise in relation to the prices that you produce (export), your real income declines. Economists call this type of drop in real income an adverse shift in the terms of trade.

Texans thought that they had a God-given right to pay just $6 to go to a movie theater. Their government decided that the movie theaters would continue to charge only $6, and if necessary the government would take over or subsidize the theaters. Thus, Texans paid for the adverse shift in the terms of trade as taxpayers rather than as consumers.

Having the state government try to absorb the shift in the terms of trade did not really work. The cost to the government of Texas of buying movies at a high price from studios and showing them at a low price to consumers mounted rapidly, and Texas could see that its state budget would be in crisis. The government of Texas then mounted a campaign to freeze the prices that movie studios could charge.

New York Times columnist Paul Krugman, who has done for the economics profession what James Jeffords did for the Republican Party, supported the Texas position. He said that there was no justification for California movie studios making profits while Texans were suffering.

Had the President of the United States listened to this advice, he would have slapped controls onto the prices charged by movie studios. This would have thrown the movie production industry into chaos and led to movie shortages and higher prices everywhere in the country.

Then, miraculously, the government of Texas asked a real economist for advice. The economist recommended two measures (in addition, of course, to removing the ceiling on retail prices):

1. Peak-load pricing.

   The movie theaters had their biggest problems when movies were in peak demand, with too many customers relative to available seats, even though most of the time there was sufficient seating capacity. The economist recommended that the the theaters be allowed to offer discounts to customers who were willing to give up their seats during peak periods and instead watch movies at other times. This helped to even out the demand for movies and increased the theaters' efficiency.

2. A tax on movies.

   In order to balance supply and demand for movies, the price of movies to consumers needed to rise. One way for this to happen without causing the money to leave Texas was for Texas to put a $2 tax on movie tickets.

   With this new tax, Texans paid particularly high prices for movies--as high or higher than the $10 maximum observed elsewhere. However, they did not suffer from "blackouts," and more of the money that consumers paid for movies stayed in the state of Texas.

   Of course, it was very counterintuitive for the political leaders of Texas to increase the cost of movies to consumers by raising a tax, when consumers thought that they had a God-given right to see movies at $6 a ticket. But the people of Texas were so well educated in economics that they understood that this was the best way to deal with an adverse shift in the terms of trade.