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.
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.
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.
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.
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.
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.
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.)
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.
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.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:
This is known as "bad luck."
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!
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.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....
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.
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.