Wednesday, August 6, 2008

The Enemy Is Us

Ok, I've been duly baited. In a post where he shares some good personal news, Roger Z takes a little digression and gives me a little shout-out:
First, a quick shout out to Chris and another hello to Tim- thanks Tim for blogging me I've now quadrupled my readership this month (you, Chris, and me... twice). Chris apparently lives down in the mountains of north Georgia, which I've been through once and are a beautiful, enchanting place, as is most of the southern Apps. Glad you stopped by and I'll be checking out your blog from time to time to make sure you're getting your economics straight. :)
Well Roger, just so happens that I've been mulling over some economic thoughts, so I think I should put them out here and let you grade them.


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We've all been hit hard by the recent spike in fuel prices, and as has become traditional in our society, our first response to this--even before we try to find solutions--is to figure out whom to blame.

That's right! If we can find out who's behind this mess, who's benefiting from it, and just make them pay, we can get back in control of the situation with a just solution.

And it would appear that the favorite bogeyman in the present crisis is Big Oil. After all, the accusation goes, just look at the revenue they're bringing in! We're getting reamed at the pumps, and they're seeing record profits. Obviously they're profiteering, making a killing at our expense!

Now, they aren't the only targets. There's also Congress; and there are the oil speculators; and there's OPEC; and so on, and so on. But the oil companies seem to come in for the worst criticism.

Now, I'm going to say something that will probably make some of you think that I'm an idiot, or that I'm "In the Pockets of Big Oil" (as if--we could certainly use the money): Big Oil isn't the problem here.

We are.

That's right, we--those of us who use the gas, are the ones who (in the current circumstance) set the prices so high.

But before the flame war starts, let me go back to first principles and give an explanation.


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Imagine a traditional auction. Say a long-lost Van Gogh has just been discovered in someone's attic, and the discoverer has taken it to Christie's to have it auctioned off. The thing sells for the ridiculously high price of seven million dollars.

First question: who's responsible for setting that ridiculously high price?

If you said "That greedy seller did," you owe me a kewpie doll. ;-)

The correct answer, of course, is that the price was set by the wealthiest and most desperate buyer. In a traditional auction, the would-be buyers are in fact competing with each other; whoever is willing and able to bid higher than all the others, is the one who sets the final sale price. And the more desperate the buyers are to win, the higher the bidding goes. In this instance, the seller is not responsible for setting the final sale price; the buyer offered to pay seven million dollars, and all the seller did was agree to the buyer's price.


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Now imagine a commodities market. In a much-simplified sense, they should be considered two-way auctions: There are numerous sellers--oil production companies, oil export companies, government producers, and the like. And there are also numerous buyers--retail gas companies, refineries, militaries, manufacturers, etc.

The buyers are under pressure to secure the oil they need for their operations; after all, if they don't get everything they need, they may have to scale back operations and cede market share. They'd like to get a low price, obviously, but they may not be able to hold out long enough for those low prices, or they will get outbid by the other buyers and not secure the supplies they need.

There are two ways that a buyer can make a trade. A buyer can look at all the asking prices that the various sellers have posted for their product; and if the lowest asking price is low enough, the buyer can say, "I'll take it." Alternatively, the buyer can decide that none of the existing asking prices are good enough, and can post a lower bid, in hopes that some desperate seller will come along and accept it--which is by no means guaranteed.

The sellers are under pressure, as well. They have oil, but they need money. Now, they would obviously like to get the highest price they can, but if they set too high an asking price, they run the risk of being undercut by one of their competitors who's just a little more desperate to trade.

As with the buyer, there are two ways that a seller can make a trade. A seller can look at all the bids that the various buyers have posted; and if the highest bid is high enough, the seller can accept it. Alternatively, the seller can decide that the bids are all too low, and can post a higher asking price in hopes that some desperate buyer will come along--again, which is not guaranteed.

Thus, a two-way auction. The buyers are competing against each other for the supply. And this competition among the buyers tends to push the prices up, as each buyer has to top the others' bids in order to make the trade. Likewise, the sellers are competing against each other for the demand. And this competition among the sellers tends to push the prices down, as each seller has to undercut the others in order to make the trade.

So who determines the final sale price in a commodities market?

Answer: Whoever is most desperate to make the trade. If the buyer is more desperate than the seller, the buyer looks at the lowest available asking price--whatever it is--and says, "I'll take it." If the seller is more desperate than the buyer, the seller looks at the highest available bid--whatever it is, and says, "I'll take it."

So if you're trying to figure out which way the price of oil will go (which, according to the Efficient Market Hypothesis, is a fool's errand), what you would need to know is whether the Buyers or the Sellers are going to be more desperate to make the trade. If the buyers are more desperate, they will bid the prices up, as each tries to secure its own supply before the other guys get it all. If the sellers are more desperate--like they were in the mid-eighties, when Iran and Iraq were desperately flooding the market with oil to bring in the cash to finance their war efforts--they will start competing against each other on price, and the buyers can pick and choose among them, bringing the prices down.


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Ok. So how do the prices work their way through to the pump? Well, it is the fear of every gas retail outlet that they will wind up running out, and have to place a "No Gas Today" sign on their pumps. Not only is that really bad PR, it winds up losing them both revenue and market share. So if they expect to sell x gallons, they must first secure a supply of x gallons (or the oil needed to make x gallons). That means, when supply is short in the markets, they must fight all the more desperately to get their supply.

Short supply causes desperation in the buyers; desperation in the buyers causes the price of oil to go up. This gets passed on to the end user--us.

If they can't get enough supply to meet their needs, they do the next best thing: they raise their prices even more. This, of course, drives some of their customers away to their competitors. It reduces their market share; but it also reduces the amount they have to supply, so it means they don't get to the point where they run out. And meanwhile, now the competitors have to figure out how to get that much more supply on the markets.

This, simply stated, is the first half of the law of supply and demand. When there is a glut, the buyers get to pick and choose whichever deal they want; the sellers are competing against each other, and this dynamic pushes the price down. When there is a shortage, the sellers get to pick and choose whichever deal they want; the buyers are competing against each other, and this dynamic pushes the price up.

The price of gas has gone up, because we the buyers are more desperate to buy than the oil producers are to sell. By competing against each other, we the consumers pushed the price up.


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Now, the second half of the law of supply and demand is just as important as the first, but is often overlooked. It's this second half that makes the Free Market the most efficient form of economy ever developed by Man.

Those prices themselves cause changes in production and consumption patterns, that tend to eliminate both the gluts and the shortages--so long as well-intentioned politicians don't get in the way.

When a shortage causes prices to soar, as they have done over the last two years, two things happen. First, the consumers of the commodity--out of a desire for financial survival--try to figure out how to cut back, or how to utilize alternatives. In the case of gas prices, if they stay high enough for long enough, people start thinking about how they can get through their days while using less fuel. They start tuning up their cars and fully inflating the tires; they start catching rides from friends and carpooling instead of going alone; they run several errands in a row instead of lots of little ones; they walk and bike more; they use mass transit. If the prices stay high a bit longer, people start changing their car-buying habits--going with economy cars, or going diesel or hybrid. And if it goes on long enough, it can make alternative fuel sources attractive--such as fuels derived from coal, or algae, or natural gas. The net effect of all of this is to reduce the demand side of the equation, eliminating part of the shortage.

Second, the producers of the commodity are faced with huge profits, and a simultaneous opportunity to grab market share--so long as they can beat their competitors to market. The high prices give the producers both the money needed to expand their operations, and the motive to do so. It also gives producers of alternatives an opening; that is, if the big players can't or won't boost their production, occasionally alternate technologies come along that become very attractive. (I think of how the Cable monopolies, who were slow to respond to public upset about their service, wound up losing a huge chunk of their market share when regular satellite TV service came on the scene.) In the case of our current fuel woes, there are a bunch of alternate technologies on the horizon--from plug-in hybrids, to biodiesel, to coal-to-liquids technology--that will be ready to step in to the gap in just a couple of years if OPEC fails to see the light. Anyway, in sum: the high prices set processes in motion that increase the supply side of the equation, eliminating the other part of the shortage.

Given enough time, the high prices cause changes in both supply and demand that eliminate the shortage, which causes the prices to settle to a new equilibrium point.

(And a similar process works to eliminate gluts and excess capacity; if there's more on the market that is needed, the prices go down. This both spurs consumption and reduces production, until the glut is resolved; then the prices rise back to a new equilibrium point.)


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So if we want to lower gas prices, how do we do it?

Basically, we have to make the consumers less desperate to trade than the producers. We have to get to the point that the producers are concerned about whether they'll be able to sell all their product at good prices, as opposed to the consumers being concerned about whether they'll be able to get what they need. To get the prices down, we have to get the producers trying to undercut each other again, instead of the consumers trying to outbid each other, like we have now.

And the way to do this? Supply and Demand.

On the demand side, this means doing those things that we all know we should be doing--conserving what fuel we can. Inflating our tires will help a little (though not as much as some famous politicians think); trip-linking will help some; carpooling; looking for more efficient vehicles; all of that will help.

Some. But I'm convinced that this isn't really enough. Our country is growing in population, after all. And we are competing for our oil against the massively growing economies of China and India, which are consuming ever-increasing quantities of the stuff. I think conservation is a good thing; but I don't think that our conservation efforts will be enough over time to supply our reasonable demands.

In the long term, I would certainly expect to see technological advances providing us alternatives to fossil fuels. We already have hybrids; soon we'll start to see plug-in hybrids which (for many of us commuters) will be able to reduce our gas consumption by an order of magnitude. Tesla Motors is out with an all-electric performance car. And there's been plenty of research lately into fuel cell technology. And then, there is all the research being done into cellulosic ethanol, coal-to-liquids, oil shale (which for the record Roger Z doesn't like), biodiesel, and a bunch of others. I see some combination of these eventually becoming standard in our transportation infrastructure.

But that won't happen immediately.

In the medium term, we've got to get more supply online. The good news is, we have enough resources within the US and off our coasts that we can at least make a decent-sized dent in our import needs, if we decide we really want to get at it. And given that the price of oil is highly non-linear, a decent-sized dent is probably all we really need to bring the price down to reasonable levels, at least until more long-term alternatives come online.


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Here's the trouble. This was stated very eloquently by Robert A. Heinlein's character, Lazarus Long:
Throughout history, poverty is the normal condition of man. Advances which permit this norm to be exceeded — here and there, now and then — are the work of an extremely small minority, frequently despised, often condemned, and almost always opposed by all right-thinking people. Whenever this tiny minority is kept from creating, or (as sometimes happens) is driven out of a society, the people then slip back into abject poverty.

This is known as "bad luck."
While long-term high prices set in motion the structural changes that eliminate the shortages over the long term, they are very unpopular. This often causes us to look to our politicians to give us "solutions" that punish the "bad guys" (who aren't), ignore the underlying supply-and-demand problem, and short-circuit the solution the Free Market would bring us if only we would let it. As I said in my previous economics post:
The trouble is, these solutions are quite popular, precisely because they are intended to alleviate suffering. Politicians win elections by running on platforms containing these solutions. It is probably to be expected then, that long-term, continuous, unimpeded economic growth is likely to be rare in human affairs; there are too many incentives for people in power to do precisely those things that derail the train.
So the price goes up, and who do we blame? The Oil Companies! What do we do about it? Well, we need to teach them a lesson, and let them know that avarice does not pay! Especially when they are taking money out of the pockets of the little guy!

Well....

Turns out, the reason their profits are so high is not that the oil companies are charging so much; it's that they're selling so much product. They actually have quite modest profit margins, compared to many other industries, in part because they are the ones paying those exorbitant prices to import all that oil on our behalf:
In the first quarter of 2008, Big Oil had a profit margin of 7.4 percent. Over that same period, the pharmaceutical and medicine industry earned a 25.9 percent profit, the chemical industry earned 15.7 percent and the electronic equipment industry earned 12.1 percent.

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Let's take a look at where each dollar spent at the pump goes. In the first quarter of 2008, the majority – 70 cents – was spent to purchase crude oil, 17 cents was spent on refining and retailing, and 13 cents on paying taxes.
Yeah, the oil companies are unpopular. But this is one of those cases where if we decide to punish them for their alleged perfidy--especially given that we are the ones who drove up the gas prices in the first place--it will be a textbook case of "biting the hand that feeds us". I think this cartoon has the right take on the whole thing....

If we really want the price to come down, the best thing Congress can do is open up federal lands for exploration and drilling. The worst thing Congress can do is demand its pound of flesh from the companies that will be doing this exploration and drilling.

It all comes back to Supply and Demand.

14 comments:

Arby said...

The reason that my van sits on "E" in the driveway for weeks at a time is not to punish oil companies. The reason we own a scooter that gets 110 mpg and is used on trips to and from work and short grocery errands is not to dramatically affect the demand side of the equation. We do these things becuase it is responsible budgeting. We cannot afford to continue to pump gallon after gallon of $4.00 gas into our van and drive...wherever. Ah, if only Big Governmenet were half so responsible. I bet I've reduced my demand on gasoline by 70-100 gallons per month, and quite frankly, I couldn't care less who benefits and who loses. That just isn't the issue.

Big Doofus said...

This was very well written. There is one other mysterious element that you didn't bring up. I'm not sure who is to blame for this, business or the consumer...

Gas Guzzling SUVs, trucks and BIG CARS that serve no practical purpose. What created the market for these beasts? The price of oil was reasonable (if you factor in inflation) and Americans were in love with big vehicles. We gobbled them up en masse. Why does a stay-at-home mom need an SUV? Why does a man who works in a cubicle need a Hummer? Obviously, we buy these things simply because we can. We fueled (no pun intended--ok, maybe just a little bit intended) the fire by demanding more and more gas guzzling vehicles. Don't get me wrong. I'm not saying that consumers are to blame exclusively and that consumers are bad. I just find this to be an interesting phenomenon.

Imagine purchasing a lamp that lit up a room AND sucked up extra electricity just for fun. That would seem a bit foolish, right? What if we bought furnaces that heated our home AND purposefully shot some of that heat outside just for kicks. We don't do that. In fact, the bulk of consumers are usually trying to figure out ways in which we can conserve these things because it makes sense. It's responsible. It also saves us money. So, why did we buy and demand all of those gas inhaling vehicles for the past ten years?

Chris said...

Tim,

Great post on a subject I've been thinking about for some time. The concepts of supply and demand really do go hand in hand here. Reducing our demand in both short-term (trying to drive less; car-pooling, etc) and long-term (buying more fuel efficient cars, etc) will help, but there is no way that we can save our way out of this problem. You stated it correctly - our country is growing; the world economy is growing; overall demand for fuel will continue to increase. I'd also note that a lot of the alternatives also ultimately require oil or gas. Plug-in electric cars require (obviously) electricity. In many places in the country, electricity is generated by gas-fueled power plants. Less demand for petroleum, but more demand for natural gas.

The great thing about the "supply" impact on prices is that, due to the nature of the marketplace, supplies don't have to actually increase to reduce prices (at least for the short term). Just the suggestion that we might remove restrictions from off-shore drilling caused the price of crude oil to drop. Now granted, if we don't eventually actually drill, that gain will be lost. But the arguments that "we won't see the benefit of drilling for 7 years" are crap. We'll see the benefits immediately.

Jarrod J. Williamson, Ph.D. said...

Tim:

While I believe the run up in oil prices is partly due to increased demand, a LOT of the run up is due to the weakening dollar.

In addition, as far as I can tell, history of replete with examples of price manipulations by the producers that required gov't intervention to stop. I am no longer convinced of efficient market theory which is based, in large part, that people will behave rationally in their own best interest. People generally do not behave rationally, IMO.

BTW, Do you think the "oil shortages" during the Carter Administration were due to supply and demand, or political manipulations by OPEC?

Timothy Power said...

Jarrod,

I absolutely agree about the exchange rate affecting the price of oil. But then, the exchange rate is itself driven by supply and demand. The more that people want dollars, the stronger the dollar gets; the fewer people want dollars, the weaker it gets.

Regarding rationality: the Law of Supply and Demand, correctly understood, is unaffected by the rationality of the actors in question. The Law predicts, basically, two things: the way prices react when there's an imbalance in supply and demand, and how these price changes affect the incentives of producers and consumers. Those incentives take the form of negative consequences for those who don't obey them, as their competitors (or customers, or suppliers) profit at their expense. So while an irrational actor may choose to ignore them, they will usually wind up suffering for it--especially over the long term.

So suppose, hypothetically, we Americans are buying much bigger cars than we need, as Doofus said. Suppose that as a result, this results in a supply/demand imbalance. This will cause prices to rise. Now, we can choose to ignore the price signal, and go on pretty much the way we were--but in so doing, we will cause the price of gas to keep rising, and keep rising, until we start going bankrupt (individually and collectively) and the Arabs and the Venezuelans have all the money they want from us.

On the flipside, suppose that a supply/demand imbalance is caused by an exporting cartel choosing to keep a lid on supply, in hopes of keeping prices high. Well, if they do it too long--ignoring the price signals to pump more or invest in new exploration--eventually their trading partners start looking for energy supplies of their own, or for alternate technologies that bypass the need for what they're selling. Oil is already well above the price point where other technologies--like Fischer-Tropsch--can break even. If the price stays here too long, OPEC risks the possibility that we--or Europe--or China--will build a viable coal-to-liquids infrastructure, and the demand for their product will drop way down.

Considering your question: "Do you think the "oil shortages" during the Carter Administration were due to supply and demand, or political manipulations by OPEC?"

Depends what exactly you mean by a "shortage". Fact is, producers are 100% in control of supply--just as consumers are 100% in control of demand. OPEC on occasion has decided to cut their production, either to punish the West for supporting Israel, or just to raise the price and boost their profits. Regarding this latter reason: frankly, as much as I loathe OPEC, it really is their oil. If they don't want to pump it out of the ground, that's their right. It's not like Americans or anyone else has a right to the mineral wealth of any other nation.

But the symptoms of the shortage that people remember from the '70's--gas lines and sold-out gas stations--really were the fault of Nixon's price controls and Ford's Whip Inflation Now than anything else. True, OPEC was cutting production to target the prices they wanted; but had the oil nevertheless been traded on a free market, the result would have been much higher prices, not sell-outs. The higher prices would have discouraged buyers, which would have reduced demand until supply and demand were in balance again. And further, the higher prices would have resulted in huge incentives to explore for more non-OPEC sources.

(As I recall, Reagen lifted price caps almost immediately on entering office. And about the same time, the Iran-Iraq war started. And not long after, the North Sea and other non-OPEC fields started producing. Within a few years, OPEC was a shell of its former self--more desperate to sell than we were to buy, and the price fell to a fraction of what it had been.)

The underlying problem in the '70's is the same as the problem today, and is exactly what I outlined in my essay: the buyers are more desperate to buy than the sellers are to sell, so the buyers are bidding up the price of oil. (Though things have started to come down lately. We'll hope it continues....)

Regarding government intervention: I'm sure we can point to instances where the government intervened and made things more pleasant for the consumer--at least in the short term. The trouble is, governments are capable of being every bit as irrational--and far more dangerous--than even the most greedy and perfidious oil company. One of the themes of this essay and my previous one on economics is that sometimes the healthy thing for an economy is painful over the short term. Because of this, elected politicians have all kinds of perverse incentives to do things that feel good in the short term, but foul everything up in the long term. I mentioned Nixon's price controls earlier; they are a perfect example of this.

A few hundred million ordinary people, each trying to find their own ways in a cruel world, are often wiser, and more informed about what they need, than any handful of bureaucrats--no matter how smart or well-educated those bureaucrats are.

Given these facts, government needs to develop an inherent aversion to intervention. I won't say there aren't times when it should intervene; but it shouldn't jump in every time something hiccups.

Jarrod J. Williamson, Ph.D. said...

Tim:

You said,

A few hundred million ordinary people, each trying to find their own ways in a cruel world, are often wiser, and more informed about what they need, than any handful of bureaucrats--no matter how smart or well-educated those bureaucrats are.

You are aware that, starting in the 90s, behaviorial finance economists started abandoning efficient market theory as some studies have shown these millions of investors are not rational and make serious errors in judgement.

Certainly the energy price jacking in California during the Davis governorship was not due to the law of supply and demand. Laissez-faire economics in that case got the CA public ripped off.

I am certainly a believer in the law of supply and demand, but there are Biblical limits to it.

Suppose I had, all by myself, created a cure for a disease that would save the life of your children. I made it at my expense, it was purely mine ... and you were desperate to have it.

Pure supply and demand dictates that I can morally charge whatever I wish, and you can decide to pay it if you like. Afterall, the cure is my property.

Do you really believe it would be moral for me to charge everything thing you own (which I am sure you would pay) to save the life of your child? Is this moral in God's eyes, or not?

Once you say no, you have abandoned pure law of supply and demand, and not the only difference between you and I is where we draw the line.

Timothy Power said...

Jarrod:

Two things.

First, regarding the "Deregulation" in the California energy market under the Wilson/Davis administrations: They called it deregulation, but in fact, it included all of the following:
1) Prices at the wholesale level were allowed to float, but prices at the retail level were absolutely fixed.
2) Futures contracts were banned. All purchases had to be made on the spot market.
3) The publicly-traded utilities, PG&E and So. Cal. Edison, were required by law to sell off all their energy-generation capabilities and buy back the electricity on the spot market.
4) All purchases of electricity were required to go through this spot market; by law, no one was permitted to make trades in any other venue.

That doesn't sound very laissez-faire to me....

All of this, of course, was in addition to the fact that California had been effectively forbidding the building of power plants, refineries, and new transmission systems for a good two decades prior to the whole mess starting--despite a rapidly growing population and the massive growth in the energy-hungry Tech industry. By the time the Davis administration rolled around, there was no excess capacity in the system--to the point where power plants couldn't be taken offline for maintenance without causing crises.

This situation could hardly be described as laissez-faire. Don't go putting that foul-up one on the free market; the only part of that market that was free was the wholesale price of electricity, and it was responding to the terrible shortages that we'd built into the system over decades of underinvestment and NIMBY-ism.

Second, we need to be very careful about what we mean by the word "law." "Law" can refer to a moral or legal code of behavior, such as with "The Law of Moses" or "Patent Law". The thing about these laws is that a person of free will can choose to do the immoral thing and break them, or do the moral thing and obey them.

Or "Law" can refer to a description of the way a system works, as in the "Law of Gravity", or the "Laws of Thermodynamics", or even the "Law of Unintended Consequences" or "Murphy's Law". And unlike the first category of laws, you generally can't break these (if they're true), no matter how hard you try.

Now, this second category of laws is not intended to outline a moral course of action. That's not their job! Their job, simply stated, is to predict the way a system will work. If these laws are in fact true, we can predict to some degree how the system will behave differently if we do X or if we do Y.

The thing to understand about the Law of Supply and Demand is that it is not, and was never intended to be, in the category of Moral Code. It is firmly in the second category: it describes the way real-world economic systems work. It describes the pressures that a particular balance of supply and demand place upon prices; and it describes the forces that prices place upon supply and demand. And it does this very well.

Now, people can certainly be "irrational", or can be moral in a way that is against their immediate material interests. They can choose to ignore these "price signals". People can choose to accept lower bids, or higher asking prices, than they could get if they really wanted them. And people can choose to keep consuming in times of shortage, or keep producing in times of glut; we're all free moral agents. But the Law of Supply and Demand predicts the results in these cases too: others will wind up benefiting at their expense, and their actions will tend to perpetuate the imbalances in supply and demand instead of allowing them to resolve. Note that this says nothing about the morality of the decision in question.

The Law of Supply and Demand does not try to tell us what is right or wrong, any more than the Theory of Gravitation does. I like the way that Thomas Sowell put it: "Many have argued that capitalism does not offer a satisfactory moral message. But that is like saying that calculus does not contain carbohydrates, amino acids, or other essential nutrients. Everything fails by irrelevant standards."

When we are faced with a complicated situation, we need to allow ourselves to be guided by both types of law. That is, the second type of law tells us how the world behaves, and what the most likely outcomes are if we pick certain courses of action. The first type of law tells us what is right and what is proper. The second type of law tells us that if we drop a rock over that ledge, it will hit someone on the head thirty feet below; the first type of law tells us that this would be bad.

So no, I do not think that one has to decide between following God's law and "following" the Law of Supply and Demand. It's as meaningless as declaring that one has to decide between following God's Law and following the Law of Gravity. They're orthogonal. People can choose to obey or disobey God, but economies always follow the Law of Supply and Demand, whether they want to or not.

Jarrod J. Williamson, Ph.D. said...

Timothy:

You said This situation could hardly be described as laissez-faire. Don't go putting that foul-up one on the free market;

While I am not being clear (my time is limited), I was speaking of the deliberate price manipulations by companies like Enron et al. Admittedly, CA "deregulation" created a fertile field for foulups; nonetheless, Enron and other similar companies not play fair and manipulated the markets.

This is something that often happens in the history of free markets, especially when companies do a really good job and edge out their competition completely. Hence antitrust laws.

You also said, When we are faced with a complicated situation, we need to allow ourselves to be guided by both types of law.

I am quite aware of "both types of law." It just sounded as though you were saying only negotiation between the producer and the consumer was the appropriate mechanism for determining price; without 3rd party government intervention ever (like many libertarians seem to believe).

And when the producers in a "complicated situation" are not guided by anything other than supply and demand and maximizing profits, does the government have the right to step in and make other demands?

Suppose I had this cure for your child and others' children, and no one else could get their hands on it until it was too late for thousands of parents. Would the government be justified in stepping in if I wanted to charge all the parents everything they owned, or would you have to wait for my conscience to awaken?

BTW, nothing personal in mentioning your children. I am a father and can tell you are a good father, hence I wanted to use something that would strike a chord with you. I have a sneaking suspicion that, like me, you would not want to wait for a competator to come up with an alternate, cheaper cure. I surmise you would demand some sort of government intervention, especially if I said I didn't want money from donations given to you, but wanted everything you owned. Or, if I said I had the cure, but was not willing to sell it to you to spare your child because you did not have enough.

Roger Z said...

Tim- dead spot on!!! "The Enemy is Us"- beautiful! I used to work in the energy industry, and was always amazed at how people would get in a huff about what "energy companies" were doing. Hello, do you think they're just producing electricity to play with it in a corner or something?

I think Dr. Williamson has raised some good points here, particularly about market manipulation, but I'm pretty sure that whatever Enron did in California a) only came about because of the very restrictions on competition you cited (setting up oligarcic (pardon the spelling) conditions that permitted price manipulation in the first place) and b) pales in comparison to what a government monopoly can do to manipulate prices and outcomes.

Which brings me to a point Dr. Williamson raised- he wrote: "Suppose I had this cure for your child and others' children, and no one else could get their hands on it until it was too late for thousands of parents. Would the government be justified in stepping in if I wanted to charge all the parents everything they owned, or would you have to wait for my conscience to awaken?"

First, I hate hypotheticals, particularly on the internet. Hypotheticals presuppose ground rules that simply don't exist- for instance, that the hypothetical listed has reached it's logical conclusion when the author poses a question. It's easy enough to tag on "well suppose if..." ad infinitum. Usually on the internet they get this way after a while.

So, what's the alternative? The alternative is this: show examples. What example do we have of someone withholding an important drug or some other product that has humanitarian consequences in a free market exchange? Let me even take back one condition- when has this hypothetical ever happened? Conversely, under what conditions would it happen?

The only market-based monopoly that's legally permissible is a patent, and the idea there is to give the inventor enough time to recoup the costs of R&D. With that exception, I can't think of another instance where a company or an individual has done what Dr. Williamson has alleged, or, for that matter, could do what he has alleged, without government (or, perhaps, geographic) interference preventing a solution.

Finally, I think when you enter into discussing regulating outcomes you need to discuss Coase's theorem. Based on it, I don't believe the government *necessarily* has the "right to step in and make other demands." That may very well be the most feasible solution in some situations, but I doubt that it's the case in all, and it bugs me that we assume government "stepping in" is the default solution to a socially suboptimal outcome. Why do we assume the government would have the answer when the market doesn't, PARTICULARLY if efficient market theory (which I'm not a big fan of in the short term, at least) isn't true? What an entire market can't solve, a bureaucrat can??? I don't buy it.

Sorry for the long post, now I know why I got a pop in guest visits, and I'm about to go bore them with something that has nothing at all do with any of this. Hola South Dakota.

Timothy Power said...

You know, I just love it when one of my commenters jumps in and answers a big tough question so that I don't have to. Saves me a lot of time. ;-)

Roger Z's excellent advice about hypotheticals notwithstanding--since I'm guilty of posing hypotheticals myself on occasion--I'd like to make a few observations about the drug price situation.

First, there is the observation that drug research is really, really expensive, and that it's really risky. Bringing a new drug successfully to market requires somewhere on the order of a billion dollars these days, if I'm not mistaken; and when one sets out to do this, there's no guarantee of success. Every drug company lives under the fear that they'll get denied by the FDA after Phase III trials, thus voiding their entire investment.

Second, it's a well-observed law, with plenty of empirical evidence, that that people usually only invest in higher-risk investments if these investments have greater expected returns than the lower-risk investments. If stock A gives me a 10% chance of losing my shirt, and stock B gives me a 20% chance of losing my shirt, I'm not going to invest in stock B unless it has a much higher expected rate of return than stock A.

And as mentioned above, drug research is really risky. No institutional investors will invest in companies that do drug research, unless there's a high expected rate of return--that is, the money to be made from sale of new drugs is enough to cover the cost of researching them, PLUS the cost of researching all the drugs that didn't make it to market, PLUS a high enough profit margin to compensate the investor for the fact that he took on a whole lot of risk.

All that means that new pharmaceuticals tend to be very expensive--not because the manufacturing process is expensive, but because the drugs sales have to recover the cost of their development with enough left over to attract the next round of investors for the next development effort. (And countries like Canada, that dictate a lower price that only covers the cost of manufacturing, wind up free-riding off the US drug market. We are the only ones paying for the original research.)

If the companies can't recover their research costs through drug sales, eventually they won't attract investment, and they will stop doing privately-funded research; the only research then will be the government-funded stuff, which is generally only a fraction of the privately-funded stuff.

Now, I argued above that the Law of Supply and Demand isn't there to tell us what is right and wrong; rather, it predicts what the consequences will be of various courses of action. Without passing judgment on the morality of the situation, the Law of Supply and Demand predicts what will happen when we restrict the price of drugs: The drug companies will be much less likely to recoup the cost of research before their patents run out. Investors will start to find the drug companies riskier investments than companies in other industries with similar returns; the money will start leaving the industry; and soon, the amount of research into new drugs is greatly reduced, potentially resulting in the loss of lives that could otherwise have been saved.

Now, none of this is to argue the morality of price controls on drugs one way or the other; rather, it is a call to understand what the consequences will be, before jumping in to make decisions that will reverberate for years. Should we control the price of a particular drug to make it available to suffering children now? Perhaps, but only if we go in with our eyes wide open, fully understanding that we may be losing the chance to help suffering children in the future--and we are confident that the decision is nevertheless the right one.

Now, as Roger Z mentioned, hypothetical situations like the one Jarrod mentioned are thankfully rare in practice. Drug companies consider it really bad PR to let kids die through lack of access to their drugs. So typically what these companies do, as part of their marketing strategy, is they give out lots of free samples to the doctors, in hopes that the doctors will start prescribing these things. Then, when the drug is in widespread enough use to be considered a standard therapy, the insurance companies and state Medicaid programs start approving them, and the drug companies start recovering their investments....

...

(Hm... that didn't actually save me that much time...)

silvermine said...

I don't know of a drug company that doesn't have a program to sell drugs to people who need them and cannot afford them.

Jarrod J. Williamson, Ph.D. said...

Timothy:

You said, Should we control the price of a particular drug to make it available to suffering children now? Perhaps, but only if we go in with our eyes wide open, fully understanding that we may be losing the chance to help suffering children in the future--and we are confident that the decision is nevertheless the right one.

Thanks for the response. It took a lot of doing (grin), but this is the response I expected.

The difference between you and I is one of degree, not one of kind. ;-)

Roger Z said...

Well if Jarrod agrees with Tim's post, and I agree with Tim's post (I didn't mean to imply that I think patents are wrong, and your point about "eye's wide open" is exactly what I was thinking... and never wrote! :( ), then discussion over? Can we begin group therapy now?

Jarrod J. Williamson, Ph.D. said...

The main point I wanted to make is that there is a point at which government should step in and interfere with business.

I am not asking complicated hypotheticals in order to merely toss around hard questions. It is no sign of intelligence just because someone can ask hard questions. Any fool can toss pebbles down a well faster than the wisest of men can retrieve them.

I am asking hard questions and making certain points because too many on "the Right" spend their time tossing around cliche's rather than actually thinking.

E.g., false cliche's like: public K12 schools are terrible (they aren't), private K12 schools are so much better (they aren't), the Rachel L. decision was an "all out assault by the Left on the American family" (yes, Dobson actually said that), etc, etc.

Being a mirror image of the Left, the Right is so engrossed with the "righteousness" of their cause that the truth is a first casualty. I cannot tell you the number of times I talked to someone on the Christian Right and it is the same old erroneous laundry list of talking points. They have the laundry list memorized, and the counter-rebuttals memorized with associated questionable statistics, that they never actually think. They are as monotonous as the Left. It's like dealing with a cult.

Anyway, I am certainly done on this point.

As far s group therapy is concerned, this is my favorite group therapy.