There's been a bunch of talk about oil prices lately. Demand for oil is going up and supply is not. People hear about the oil companies' record profits and they wonder why these companies don't pass some of the windfall on to consumers, thus lowering fuel prices. So-called economists get on the air and dogmatically spout out "supply and demand" as if that actually explains the situtation to 95% of the public who hasn't taken an economics class.
Having had some real world experience with this just from working in industry, here's how the mechanics of supply and demand work in this particular situtation.
Supply of oil is flat. Maybe it's because we haven't built any oil refineries, or maybe it's becasue the wells in Saudi Arabia are drying up, or maybe it's because we haven't opened up Alaska to drilling, or maybe it's because we still burn a shitload of oil for electricity production rather than using nuclear, or maybe all of those things, I don't know. But I am accepting it as a fact that supply of oil is not growing. Demand however is growing, and when a flat supply meets a growing demand, one of two things can happen. Either you do nothing, allowing shortages to occur leaving millions of people stranded, waiting in gas lines, or you figure out a way to slow down demand for your product enough so that it is in line with supply.
Let's see, what is the best way to decrease demand for a product? Could you lower its quality? Gasoline standards are very tight, and so no, you couldn't lower quality, there are laws against that. Could you spur competition to increase supply? Yes, and in fact, that is happening to an extent with alternative fuels and new nuclear plant construction. But that is a long term fix, and is useless for short term increases in demand (like the current summer driving season). The last option available to you then, is to raise prices. Making the same product more expensive lowers demand for that product, forcing people not to use it as much, but also preventing shortages of the product.
Its almost like the oil companies can't help but make a huge profit.
6 comments:
There is a nice economic principle thread going on in several blogs I read, totally independently.
Casey, I love what you're saying. It is certainly true, but there are some other factors at play. Read this blog entry from Asymmetrical Information. http://www.janegalt.net/blog/archives/005761.html The problem with raising prices is that unless you mandate it through legislation (something I am loathe to do). Remember, supply of oil is not flat, but finite. Supply is what is available in the market and much of the oil is not available. OPEC is pumping as much oil as it can right now and still not meeting demand. In fact you could argue there is a shortage. This is how you get your higher prices. OPEC really has control over prices.
Also, don't spead misinformation: price is a function of demand, not the other way around. Fixing prices does not change demand it changes quantity demanded. Very different, not just a semantic difference.
Finally, I like your solution, but that solution should be a market result (retailers, refiners or OPEC). In fact I would say that the reason prices are not higher are the result of fear of government legislation against them should prices go off the charts.
Okay everyone, ignore the next few posts until Tom and I work out some sematic differences. I have never taken an economics course in my life, so I don't know the jargon, let's see if we can nail it down.
"Remember, supply of oil is not flat, but finite. Supply is what is available in the market and much of the oil is not available."
Then isn't my original statement true? The oil available in the market is not increasing, thus it is flat, which is what I meant. No?
"OPEC is pumping as much oil as it can right now and still not meeting demand. In fact you could argue there is a shortage. This is how you get your higher prices. OPEC really has control over prices."
To me, a shortage is what happens when I go to a gas station and they tell me they have no gas available at any price. I was not using the term "shortage" in the sense that there is a greater relative demand for a product than a past relative supply. Maybe I should have used the word "outages"?
"price is a function of demand, not the other way around. Fixing prices does not change demand it changes quantity demanded. Very different, not just a semantic difference."
I agree that price is a function of demand. But that's a total abstraction and doesn't help anyone listening to a talk show who wants real-world understanding of why gas prices are so high. I attempted to explain the actual mechanism behiond the abstraction. If you want me to re-state what I said by sayign that gas companies are raising prices to reduce the "quantity of demand" rather than demand itself, then fine, I can go with that change and I understand why you are keen to make the distinction. I think most people in the public would get what I mean if I just called it demand though. Raise the price on a product (gas) and it becomes less desireable a product, ergo, less demand for gas (or less "quantity of demand" as you put it). The alternative is to let outages of gas occurr, which ultimately is a far more costly strategy for a gas company as it tends to only fuel political outrage. Eventually though, prices will get so high that it will be essentially the same thing as if there were outages, as only rich people could afford gas.
"Finally, I like your solution, but that solution should be a market result (retailers, refiners or OPEC). In fact I would say that the reason prices are not higher are the result of fear of government legislation against them should prices go off the charts."
I didn't think I had a solution there per se, but if I did have one it would be to repeal all gas company subsidies permanently and use the savings to build 400 more nuclear plants and 1000 more biodiesel and ethanol plants. Again though that's a long-term solution, the short term is going to hurt and I don't see any solution to that at all.
I would also agree with you that the reason why prices are higher is becasue the gas companies have a fear of political retribution. I guess I see what you mean when you said that in a way we already have shortages. By raising prices, we basically stop supplying poor people with gas, as opposed to the situtation I suggested where only people who live near a certain gas station are deprived of gas. The percent of people deprived of gas might be equivalent but I think it works better to freeze people out of buying gas for economic reasons rather than geographic reasons only becasue peole feel that they have control over thier econmic fate, but they can't help where they were born and live quite as much. That might not actualy be true of course, but I think the perception is correct, and as they say, perception is reality.
I would also agree with you that the reason why prices are not higher.
I menat to say are not there. Sorry.
>Then isn't my original statement true? The oil available in the market is not increasing, thus it is flat, which is what I meant. No?
The oil in the market fluctuates daily. Oil still in the ground does not constitute oil in the market because it is what we call a primary good. Not that it has not value at all, but its value exists in the futures market. Oil rights have value but the oil itself is not considered in the market, as you have defined it, until it has been extracted. The supply of oil changes dynamically, but is a finite resource.
>To me, a shortage is what happens when I go to a gas station and they tell me they have no gas available at any price. I was not using the term "shortage" in the sense that there is a greater relative demand for a product than a past relative supply. Maybe I should have used the word "outages"?
Shortage- A condition that exists when demand exceeds supply because of a lack of equilibrium in a market. If a price is artificially low, buyers want to buy more of a good than sellers are willing to sell.
>I agree that price is a function of demand. But that's a total abstraction and doesn't help anyone listening to a talk show who wants real-world understanding of why gas prices are so high. I attempted to explain the actual mechanism behiond the abstraction. If you want me to re-state what I said by sayign that gas companies are raising prices to reduce the "quantity of demand" rather than demand itself, then fine, I can go with that change and I understand why you are keen to make the distinction. I think most people in the public would get what I mean if I just called it demand though. Raise the price on a product (gas) and it becomes less desireable a product, ergo, less demand for gas (or less "quantity of demand" as you put it). The alternative is to let outages of gas occurr, which ultimately is a far more costly strategy for a gas company as it tends to only fuel political outrage. Eventually though, prices will get so high that it will be essentially the same thing as if there were outages, as only rich people could afford gas.
A couple of things here...1st you touch on a very important point which is economics and policy are intertwined but may function at odds. So what might be the best economic solution carries political costs. I think that you are a bit caught up in the verbiage...let me try to explain...
Damn I can't paste a graph here...
Ok well lets try this. Some of this may be over obvious, but I don't know what you know and I cannot give you a picture here:
A supply and demand graph is a linear representation that lies in the 1st quadrant of the x-y plane. The x axis is quantity demanded and the y-axis is price. Supply is represented by a positively sloping line and demand by a negatively sloping line. The point at which the 2 lines meet is called the equilibrium point and gives us the equilibrium quantity demanded and price. We also call this the market clearing point because this is where supply=demand and there is no shortage or surplus in the system. So at this point we have a price and a quantity demanded...both of which are endogenous variables. Remember, the demand and supply functions are determined exogenously. So what happens if the price is artifically pegged above the equilibrium price due to legislation? This does not change the supply or demand. What happens is the price will now intersect the 2 lines above the equilibrium point where supply meets demand. Now the new horizontal price line will intersect the demand line at a lower quantity demanded and at a greater quantity supplied than equilbrium. Therefore supply will exceed demand and we will have surplus.
Back to the oil example...if gas is decreed to be $5 a gallon, then some people will stop buying due to not being able to afford it, others will cut back thier consumption. The quantity demanded will fall. In the short term, demand does not change since if prices were to drop to equilibrium, consumption would rise back to that quantity demanded. At this new price suppliers will want to sell more gas which is refelcted in a higher quantity supplied. Higher quantity supplied vs lower quantity demanded creates surplus. Remember neither demand or supply have changed.
Shortage is the opposite.
I'm with you on everything. I did just want to say some thing about the first part. When I was speaking about the "oil in the market" of course I wasn't talking about the stuff in the ground. While the exact amount of gasolinein the market does fluctuate from day to day, if you look at the averages, you will see that supply has been stuck in the ~8.5 million barrels per day range since 1997. Ergo my original statement, "supply of gasoline in the market is flat" is still true. I was never talking about the oil in the ground. The supply of oil as an average is not dynamic, its flat. I made a graph from that data, find it here.
Check out April 30th entries...
Posner is a federal judge and Becker is a Nobel Laureate econ prof at UChicago.
http://www.becker-posner-blog.com/
Post a Comment