Monday, May 5, 2008

Misunderstanding of basic economics by the left

This post is a great example of how so many political commentators on the left have no understanding of basic economics. I like how the readership attacked the author's completely flawed logic. But if somebody can be this wrong on a the simplest of economic issues, why trust the person's judgment on so many other issues? I'd guess that at least half of all political issues are really economic issues. If this blog doesn't understand how basic supply and demand sets the market clearing price, how can this blog be trusted on issues such as taxes, wealth redistribution, social security, and government spending. The answer is that it shouldn't. To the authors of the blog, I recommend they pick up a copy of Economics in One Lesson.

People need to understand that the price of oil is not going up because oil companies are greedy. I don't even know what people really mean when they call a company greedy. All companies strive to increase profits. If they could increase their profits simply by being greedy, every company would do so and Making More Money with Greed would be a class taught at all business schools. No, of course, basic economics teaches us that in a free competitive market, companies cannot simply make more money by continually raising prices. There would have to be enormous amounts of collusion to do so and experience has generally shown that collusion doesn't work in the long term because the incentive to cheat is too great and there is no legal way of enforcing the collusion (even OPEC has trouble with this).

There are real economic reasons why the price of oil is increasing. First, the supply is practically fixed over any short or medium timeframe. Bringing on new supply is extremely capital intensive and takes years of development. And there is some evidence that oil production is peaking. Recent news out of Russia indicates that its oil production is decreasing. Even the recent oil discovery off the coast of Brazil could take 10 years to come online and they will need to invent new technologies to extract oil six miles below the surface of the ocean. What this means is that increased demand of oil can not easily be met with increased production. The world consumes (or saves in the case of strategic oil reserves) all the oil produced every day.

Second, the demand for oil is increasing. Countries like China and India are using more oil than ever before as their citizens become wealthier and desire luxuries such as automobiles, electricity, and energy-intensive goods. As the demand increases, the price must rise in order for the market to clear. If the price didn't rise (like if there were price controls), there would simply be shortages. The lack of increasing prices wouldn't slow down consumption and so there would just be a shortage where some people couldn't get any oil even if they were willing to pay more money for it. This is what happened in the 70's.

Third, oil isn't rising as fast as people think. The dollar is falling in value. Oil hasn't gone up nearly as much when priced in Euros. It's barely gone up when priced in gold. The United States has an economy with huge imbalances. We import more products than we export. One of our biggest exports is debt. This is not sustainable and it means a falling dollar.

But politicians don't like to let basic economics get in the way of proposing stupid policies. For example, Hillary Clinton and John McCain want to get rid of the federal gas tax this summer as a way to help American consumers. Well, I am all for reducing taxes, but they are mistaken if they think this will have much impact on gas prices. The gas price is where it's at because of the supply and demand curve. If they remove the tax, it's not likely to result in much lower prices because that would lead to additional consumption and there is no more additional supply to consume (at least in the short term). The price might drop a little bit as more supply is shifted to American consumers away from foreign consumers who not receive a tax decrease, but this would probably be fairly small.

Clinton proposed a windfall tax on oil companies. Yes, oil companies are making record profits, but most of their profits are reinvested back into R&D for finding and extracting more supply. In a free market, capital always goes where it's most favorably treated. If the government increases the tax on these profits, investors at the margin will move some capital from oil companies into other sectors. Oil companies will then subsequently reduce investment in R&D. This will ultimately lead to less oil production in the future. That of course will eventually lead to higher oil prices. If politicians want lower oil prices, the best thing they can do is allow oil companies to make huge profits. The potential for huge profits attracts more investment into this space. This results in increased future production which will help keep prices lower. This is how a free market self-regulates.

Finally, Clinton, McCain, and Obama all believe that global warming is a problem and that we must reduce greenhouse emissions. How do they expect this to happen if not due to rising prices. If they want people to use less oil, a rising oil price is one of the most effective ways to accomplish it. People will want more efficient cars and this will incent automobile manufacturers to meet that demand. People will carpool more and drive less, which will help reduce emissions. Also, high prices increase investment in alternative energy sources and make alternative energy more competitive.

In summary high oil prices are here to stay as long as the demand for oil is so high. A worldwide recession might reverse the trend, but barring that, it's unlikely for prices to fall substantially. Government cannot magically make oil cheap. High prices are the result of people competing for scarce goods. The only way to reverse that is to reduce demand or make the item less scarce.


Vijay said...

What if oil companies invested a large fraction of their profits in stock buybacks? Some companies, like Exxon, do that.

That leaves arguments about reinvestment open to criticism, and this is a line of attack that Clinton has used.

I think the real answer is that those who invest capital or labor to create some product or service have the moral right to the proceeds of their labor (including using the proceeds in ways that others may perceive to be non-optimal).

What Clinton and Obama are doing with their populist attacks on oil companies is denying this moral right and claiming that one's labor is owned by the collective.

Jon Perlow said...

When companies buy back stock, that isn't a form of investment. It's a mechanism to return capital to shareholders. The shareholders get the capital and then can invest it as they choose. A company returns capital to shareholders when it thinks it can't invest the additional capital in a way that is more productive than its shareholders can. If companies didn't return capital either by buying back or stock or issuing dividends, they would accrue capital beyond what they can invest in their core and would become investment companies like Berkshire.

Exxon and other oil companies are returning capital because it's not possible to invest all of it in production, but that doesn't mean they don't invest a large amount of their capital into production. In 2007, Exxon had operating income of $70B and they spent $20.8B in capital and exploration expenditures and $814M in R&D. That seems pretty significant to me. Maybe some of the capital being returned ot shareholders is invested in the future of energy like alternative energy. I am guessing a lot of it is also returned to pension funds and 401(k)'s. You don't really hear people talking about that part.