Asymmetrical Information

Collusion.

But I don't think that's it.

Oligopoly!

(a) All demand is being met at the price being charged. A lower price may cause resources to be shifted elsewhere to capture better prices. Rationing would only occur if producers held back/shifted product elsewhere if they weren't able to obtain what they consider a reasonable price.

(b) This assumes a greatly simplified market pricing mechanism for gasoline. There is no direct formula between rising oil prices and gas prices. Also, the relevant figure is profit margins and not profits.

(c) The market balancing act is never instantaneous.

Fear of future supply shortages.
Fear of future demand increases that supply cannot meet.
Fear of government takings - take the money now because tomorrow there won't be any money to take.

One point to the question - I don't think its safe to assume that all demand is being met. If oil prices were low I don't think it unreasonable to assume that the US would be consuming much more oil than we currently are (bearing in mind that gasoline only makes up 40% of oil consumption)

A very interesting article at the www.theoildrum.com talks about how Americans often misunderstand the factors that determine gasoline prices. The article is titled "The Politics of Oil: The Discourse Must Change" is very enlightening! It says...

"The major factor that determines gas prices is the price of crude oil from which gasoline is derived. When crude oil prices are high, so are gas prices. The following are just a few factors that affect the price of a barrel of oil:

Oil companies do not single-handedly determine the price of oil. The price of oil is set on the crude oil futures market. Simply put, these prices are affected by supply and demand because, at present, oil trades in a global commodity market where increased demand or reduced supply in one place instantly translates into price shifts everywhere. A variety of publicly available information sources show that supply is relatively static at the moment, while world demand continues to grow as economies grow.
We have provided evidence many times at The Oil Drum that the output of major oilfields is declining and that we may now have reached a peak or plateau in global oil supply. Oil companies have not been able to increase production for a number of years, and it is unclear that OPEC is accurately reporting their reserves. Even if there were significant sources of high quality oil remaining, it is getting increasingly difficult and expensive to drill. These factors, along with aging infrastructure for oil exploration and a retiring workforce are also contributing to high oil prices.
The geopolitical situation is volatile, and an astute citizen may notice that every time there is news from Nigeria or Iran, the price of oil goes up because of the potential and real effects of these situations on world oil supply. Again, oil traders are fearful that the supply will not remain stable forever.
Countries like China and India are industrializing at a great pace, and while we are accustomed to obtaining oil at a comfortable quantity and price, it will be impossible (and immoral) to deny similar resources to these countries. China is working furiously to secure new oil supplies, and they're content to negotiate with countries we're reluctant to deal with, like Iran and the Sudan.
These points demonstrate that disruptions in the supply of oil that affect the price of gasoline at the pump are not just a temporary glitch. For various reasons--decreased discoveries of new oilfields, geopolitical instability, international competition for oil supply--we can no longer assume that we will be able to consume as much oil as possible, or ever get it again for $1.50 a gallon."

(a) is not true. By the price going up, some people must have stopped buying. If exactly the same amount of demand exists at the recent high price as at the previous low price, the price would go higher still.

" prices are increasing faster than the marginal cost of additional supply to the oil companies (profits are increasing); "

Huh??

Demand shifts to the right, and so the intersection with marginal cost is at a higher price.

Marginal cost is higher than average cost, and profit is price minus average cost (*not* price minus marginal cost).

So when demand goes up, short-run profits go up. And they go up a ton when supply is inelastic (meaning difficult to adjust) in the short run. It's the profits on the inframarginal oil that go up, not the profits on the marginal oil.

That's why they're termed "windfall profits." In the short run, it seems like a good idea to tax them away.

The problem is that you want some long-run supply response (positive elasticity). And if you tax windfall profits, you tend to kill off the long-run supply response, because why invest in capacity if Congress is going to steal your profits?

a) is surely false on the global level, even if it might be true in the U.S. No American consumers may be reducing their expenditure to any great degree at higher prices, but surely third worlders without fuel subsidies are.

But demand for gas *is* about 1 percent below last year's level at the current price, so (a) is not quite true. Demand for gas is fairly inelastic, especially short term, but not totally inelastic.

Also, the comments about futures is true. The futures price, driven by speculation about political instability in many of the oil-producing countries, affects the current price. For the suppliers at least, they have the choice between saving oil for the future or hoarding it now.

Another possibility has to do with restrictions on new entry to the market, especially environmental restrictions on new wells.

Also, profits can increase without prices increasing faster than the marginal cost of additional supply of oil, especially when lots of the earlier supply is cheap per barrel, but the marginal cost of the last extra barrel is high. If they charge the marginal cost for all barrels, as happens in a commodity market, then profits (raw and in terms of percentage return) increase when the marginal cost of the last barrel increases.

There IS a supply problem - not with crude oil, but with refineries. There isn't enough capacity to meet the usual summer peak in fuel usage. These shouldn't be maxed out yet, so I think there is some anticipation going on. That is, some companies must be stockpiling gasoline now in the expectation that they can get a higher price for it this summer, and this is pushing up prices.

Isn't this exactly how a free market where everyone has good information is supposed to work? The current price rise gives those who weren't paying attention a price signal that might lead some to start looking for ways to cut down consumption before we're in a full-tilt shortage. The stockpiles built now will blunt the shortage and price peak later. Those who invested in building the stockpiles hope to get a sufficiently higher price to pay for the cost of storage plus a profit to cover the risk and the other investment opportunities passed up.

Unless the government interferes...

(b) is totally not necessary for profits to increase.

Let's think about it this way. I'll even let demand be constant. Radically simplify and suppose that an oil company can produce one barrel of oil each for $10, $20, $30, $40, and $50. Suppose that demand is for 5 barrels of oil. Then profit is $40 + $30 + $20 + $10 = $100.

Now suppose that the marginal cost of the fifth barrel of oil raises to $70, the marginal cost of the other barrels remains unchanged, and that demand is unchanged at five barrels. Suppose that the price rises at exactly the same rate as the marginal cost of additional supply to be $70. Then the profit for five barrels is $60 + $50 + $40 + $30 = $180.

Profit increases, despite prices increasing no faster than the marginal cost of additional supply. This inevitably happens if the cost of the most expensive marginal barrels produced increase more than the cost of the cheaper, more profitable barrels and demand remains the same.

Profits are perfectly at the equilibrium level, right at marginal cost, yet rise both in gross amount and as a percentage of costs or investment. Demand remains unchanged.

There, that solves the supposed puzzle.

Not surprisingly, Arnold Kling basically got it, but I'll try to add a little to his answer. The marginal cost of adding supply is a complicated issue, especially in the oil industry. It's possible to add supply, but it takes time and requires long-term capital investments. If an oil company starts expanding supply today, the oil market may look substantially different by the time that supply becomes usable.

In a thick market, price is going to be equal to cost of production plus a normal profit in the long run. But in the oil market, the long run is really, really long.

"(Lynx, Central Florida's) transit agency says it has seen a 10 percent increase in ridership between February and March. It's a similar spike to last year when gas shot up following Hurricane Katrina." - Central Florida News 13

Admitedly local and anecdotal, but if this is happening elsewhere, too, isn't it evidence that "rationing is occurring...via the price system" or do I misunderstand the concept?

I have a vaguely related question: does anyone know what factors influence the price of diesel relative to gasoline? I remember when diesel was cheaper than the lowest grade of gas (and everyone was buying diesel VW Rabbits as a result), but now it's as high as premium if not higher.

Refining capacity is a huge constraint. Three US refineries are still down from Katrina, representing about 5% of the total US refining capacity (i.e. Supply). Most oil companies attempt to operate refineries at a utilization level of about 88-90%, which allows downtime for maintenance of an extremely complex set of equipment, and utilization above this level is generally not sustainable.

Expanding refining capacity requires huge capital investments, long lead times, and the ability to overcome political and environmental challenges that can tie projects up for years, if not decades, and which add enormous uncertainty to the decision making process.

Layer on top of this the proven tendency of our politicians to capriciously change the rules under which oil companies operate, a patchwork quilt of regulatory requirements for fuel specifications, and the enormous long term liabilities associated with SuperFund; and you have an environment in which executives are very hesitant to propose a new refinery or expansion of capacity at an existing refinery.

Maybe this is simplistic, but I was always taught that price WAS a rationing mechanism.

"...no rationing is occurring (via the price system or otherwise..."

The price system is ALWAYS rationing, that is its primary function. Zero rationing can only occur if the good is available in infinite supply at zero price (e.g.: information).

It's also worth pointing out that marginal cost is impossible to observe in most cases and therefore B cannot be accurately substantiated.

OK, Here's how it really works:

GW gets on the phone with his "cronies" in "Big Oil". They call Haliburton and give them a contract to pump out CO2 at strategic places in order to create large hurricanes and other environmental disruptions.

GQ communicates to oil execs to buy oil futures. Special forces then go in and blow up oil supply lines in Iraq to disrupt supply.

This is how the "profiteering" works. Neocons are involved somehow too.

Jane, rationing is always occurring in any market. The assumption behind economics is that goods are scarce. Non-scarce goods (i.e., air, before the industrial revolution anyway) simply are not marketed, so they have no price. But all normal goods are scarce, and have prices, which balance the supply and demand.

Let me back off that slightly. It is theoretically possible to have a good with both (a) very low price, so low that every single person can meet it, and (b) absolutely inelastic demand. That is a vertical demand "curve". This good, if it existed, might satisfy your (a). But no such good exists, to my knowledge.

Ah. Arnold Kling and John Thacker remind me why I'm a law/poli sci person, not a microecon person. Sorry for the inaccurate technical phrasing in (b). (Although, Arnold, aren't we talking about a decrease in supply [via Katrina, Iraq, Iran, ] rather than an increase in demand? Nonetheless, your explanation makes sense.)

Thanks, Jane, for posting this.

On the more general topic, John Thacker has the basic idea. Let me rephrase it my way though.

Consider an oil company that produces no oil of its own - that is, it buys all oil on the international market at spot prices. As oil prices rise, competition drives the gasoline price down only to the level of the oil price. Thus, this company makes no windfall profits at all.

Now consider a company that produces half of its oil from its own wells. Those wells were created mainly via sunk costs, and in an oil-price environment where $20/bbl was profitable. Their marginal cost of production is thus less than $20/bbl - probably much less, maybe $10/bbl. So, now oil goes to $70/bbl. Half of the oil the company sells still is bought at the market price. But half is now still its own oil, costing it just $10/bbl. So the profit per barrel of the local stuff goes up from $10 to $60. Mmm, windfall. Profit on the other half of the oil is minimal, but overall profits are strong.

Now your key question is, why doesn't competition drive the price down to $20 again? Because only half the demand is met at that price. If people really could quickly reduce their usage in the short run, then this might happen. But demand for oil is not very elastic.

On the other hand, Dan Nexon makes a good point in the comments to Drezner's post. What if the windfall tax is used to fund substitutes (like public transportation) to make demand more elastic? Can't that stand in for investment in supply?

Sort of dove-tailing onto what Arnold King astutely noted -- that profit = price - average cost

Shooting from the hip, knowing nothing about oil industry as a business, -- assume that an oil company operates on 10% margins from every barrel of oil it sells, when oil is at $50/barrel they sell 150 barrels , they make $5/barrel profit for a total of $750 -- when oil is at $100, they make $10/barrel and sell 100 barrels for a total profit of $1000 --- margin stays the same, but absolute profit goes up (assuming of course that demand doesn't drop proportionally (in this example, drop to 75 barrels demanded)--- since demand for oil is fairly inelastic, that is a very safe assumption.)

I'm with Arnold.

If demand has gone up, the in the short term the price will go up, and inframarginal oil will become more profitable. Over time, at the new price, either more oil will come online AND/OR economies will substitute to lower energy intensity activities faster than they already are.

-winterspeak

Defacto rationing is occuring.

I have cut back on usage. I found a job closer to home, stopped driving 60 miles (round trip) to see some movie that was only playing far away, and borrow my mom's diesel Jetta if I have to go any sort of distance somewhere rather than drive my gasoline car, etc.

It seems to me that the commenters are missing the fallacy in (c) "no oil company is competing on price ... "

Nobody believes it, but oil producers are pulling a dreary, 100% fungible, highly storable commodity out of the ground, and they are price takers (yes, even OPEC countries) in a very liquid market. Anyone who sold their oil low would simply be leaving money on the table for speculators to flip the product for a quick profit.

But surely the astute readers of JaneGalt.net know how markets work?

I'd dispute the accuracy of "b" over the long term, and bet that the present price premium over immediate marginal cost is a response to expectations of a severe shortage in the near-term future (either because of fears about events in the Middle East, or because of fears about Congress losing its mind and instituting price caps).

Purple Avenger,

Defacto rationing is occuring.

Not really. Well, prices always act as a "rationing" mechanism, but that's what they're supposed to do. You're simply altering your behavior in response to the high price (and you apparently think it will be permanent since you sold your home).

There's clearly not a shortage of any sort, which is what I initially inferred from your comment (de facto).

Sorry, that thing about your home should read "switched jobs"

Jane

You might want to have your readers take a crack at a discussion of the effects of time on the views of the marginal cost of additional supply.

As one of your readers noted, there is a substantial portion of the additional supply tied up in 'difficult input' supply: Venezuela's Orinoco heavy oil, the Canadian tar sands, and coal( for coal-to-liquid transofrmations). Most of these sources are ripe for profitable and economical development at the present price of crude oil,but the time dimension to their development is huge. The tar sands projects simply cannot get enough people and materials to the sites to progress source development on fast track schedules, in circumstances where there are no siting issues. Coal-to-liquids projects have to begin, as do new refinery developments, with the resolution of the siting issues before the issues of personnel and equipment fabrication have to be considered.

For the United States, with large supplies of coal in very diverse locations, the question that you might ask your readers is what is the best thing that the United States government could do to expedite the creation of coal-to-liquid transformation facilities,so as to affect the availability of additional supply to the market.

I suspect that the answers to your questions (b) and (c) are embedded in the time horizons of the market suppliers. Oil companies are interested in competing on price only when such competition will allow them to utilize otherwise wasted production capacity and make profit that makes marginal contributions to the cost of that idled capacity. That is certainly not the case today for any of the US majors. One would hope that the majors are setting their profit objectives to accomodate the time cost of that additional marginal supply two decades down the line,given the length of time it is going to take to bring one of the highly-mechanized alternative sources on line.

It may well be that there are sufficient undeveloped and undiscovered conventional oil fields to replace the volumes now being extracted and used. But it does appear that the long term thinking of the industry is focused on the 'difficult input' sources for hydrocarbons.

Jane

As a further thought youmight also ask your readers from New York State to consider what the state should do to encourage the production of fuels in New York State. New York State still does produce very small volumes of natural gas and crude oil in those areas adjacent to the initial Pennsylvania oil extraction areas. But there's little more to exploit there.

But New York State does have other sources of fuel inputs, namely its forests and its agricultural industries. Agriculture is actually one of the top two or three industries in New York State, with a potential for further exploitation. There are already plans to convert the old Miller brewing facilities in Fulton, New York into an ethanol facility. But should New York State being doing more?

Everyone I know is actually *thinking* about when they can consolidate auto trips, what auto trips to cut back on, and so on. Whether you call that "rationing" or "elasticity", it *is* occurring.

And it is cutting economic activity, as well, because sometimes we just don't *do* what we would have if gas were cheaper.

To answer the question about the price of diesel fuel, what happened is that there were new regulations requiring lower sulfer content. This means either better feedstock or more refining is required.

As other commenters have noted, the first assumption is probably not true. The price mechanism is rationing demand, and demand would outstrip supply at lower prices. Worldwide demand for oil has been increasing at a significant rate for years and is likely to continue to do so. Increasing demand and stable supply lead inevitably in a free market to a new equilibrium at a higher price.

My understanding, based admittedly on limited information, is that oil companies are having trouble producing enough oil to meet the current and anticipated worldwide demand. This suggests that price is being influenced more than usual by the anticipated higher cost of finding, developing, and producing new sources of oil (for example, deeper water oil deposits, tar sands, or known but currently uneconomical oil deposits).

Further, the market fears a disruption in existing oil supplies. This situation makes existing supplies more valuable as market participants anticipate a new equilibrium at a lower quantity and a higher price.

Paul Gowder -

The posting you mentioned also talks about using the windfall profits tax proceeds to fund research into alternatives. This brings up the usual question of who is more efficient at finding new alternatives - government bureaucrats or the market. There's abundant evidence, and a lot of common sense and academic theory, all pointing in the direction of the market being far more efficient at this than the government.

Incentives matter - if the 20th century taught us anything, it should be that. And central planners seldom, if ever, have either the right incentives or sufficent information. Besides, betting everything on one set of bureaucrats is an undiversified and hence excessively risky approach. Think of the Great Leap Forward - markets could never have achieved famine throughout all of China, Tibet and Xinjiang all at once, but having them all controlled by Mao made this unprecedented feat possible.

As for subsidizing buses and other public transportation - I think they're already pretty heavily subsidized. People who want more car pooling and public transportation, it seems to me, must have painfully simple lives. If I car pool, then who picks up food on the way home, or drops off dry cleaning, or picks up medicine from the drugstore? Do I shove my young children out the door with a handful of change and just hope they find their own way home from daycare each evening? And what if my child needs therapy? Do I tell him, 'tough luck! Medical care could change your whole life, but I don't have time for both, and public transportation is just more important'?

With higher prices, each person can make his or her own decision on whether riding the bus makes sense. If the poor are too heavily hit by higher fuel costs, then it may be appropriate to subsidize them somehow, but not in a way that involves some distant government bureaucrat deciding on a one-size-fits-all solution and forcing it on everyone.

It's the same old question of which works better, market pricing and allocation, or central planning. Markets aren't perfect, but the alternative tends to be far, far worse.

I may not be able to answer (b) or (c) from personal experience, I can tell you that the higher prices is causing some "rationing"--that is, the higher price is causing less gasoline to be consumed.

I know this because my commute to work, which this time last year was talking an average of 50 minutes one way is now down to 35 minutes. There are fewer people on the road now than there was this time last year--and fewer people on the road means less gasoline being consumed.

d) inventory is not constant.

a,b,c is possible but not sustainable?

d) inventory is not constant.

a,b,c is possible but not sustainable?

Indeed. That is the focus currently.

The market balancing act is never instantaneous.
Fear of future supply shortages.
Fear of future demand increases that supply cannot meet.

Which is what drives the futures market, which is driving the current market.

But it is not sustainable. Either we get the shortages, or prices crater. Should be interesting to see what actually happens.

(a) is not true. Gasoline is being rationed by price. It the price remains high or goes higher for a sustained period, consumes will find ways to reduce their consumption still further by choosing more fuel efficient cars, car pooling, making fewer discretionary trips, ect.

(b) companies do not price their products based on the cost to produce them, but rather they set prices to maximize profits. When a company judges that the demand for its product may outstrip its ability to meet that demand, it will raise prices to maximize profits on what it can produce.

(c) this is not true. It just does not happen instantaneously. If there is a sudden change in the supply/demand equilibrium, demand exceeds supply for example, all competitors will temporarily be able to reap excess profits. As supply and demand come back into balance and remain in balance, competitive forces will gradually reduce the profit margin to a level that will attract investors given the perceived risks. If the disruption were in the opposite direction, supply exceeds demand, all competitors may suffer inadequate profits, or losses, for a time until supply and demand are again brought into balance.

Are you talking about crude oil or gasoline? They are different markets.

As to crude, there is a time lag between investment and new production, so the correlation between cost and price can be seen only by looking at a considerable length of time and factoring out the variations in supply (think Iraq and Katrina) and demand (think SUVs and China) which occur during that time frame. Crude oil producer profits will stay high until old production is restored, new production comes on stream or demand dips.

The gasoline market behaves differently. Supply is relatively constant, demand is increasing somewhat, and as a consequence refining margins have increased a little. Input costs are largely driven by crude oil costs, which get passed on as part of the finished product cost. Perhaps new refinery construction would bring down gasoline prices, but not by very much.

There is several times as much capacity in auto gas tanks as there is in all the tank farms of America. People can go a long time driving just about as much, and only putting $20 in the tank instead of filling, if they are upset with the price they face.

Almost as an aside, it's worth noting that (a) is simply incorrect. There is rationing via the price system. No rationing via the price system means price = 0.

Hi Jane:

Although Arnold Klein pretty much answered it already, here it is again, since most people only read the beginning and end of comments.

The main problem is that oil pumping/refining capacity is difficult to increase in a short period of time, and the global demand for oil (at the previous equlibrium price point) is increasing faster than global oil output capacity, and companies cannot respond quickly.

This results in market-wide "monopolistic rent" (just a term I made up). But basically, it means that since there isn't enough capacity in the market, prices do not fall to marginal cost - companies can price at whatever the demand curve will bear. (For visual learners, the supply curve simply isn't long enough to intersect the demand curve - there simply isn't enough supply, in absolute terms)

Does this mean the market has somehow failed? No - this situation is not stable. Each company has an individual incentive to increase capacity and sell more oil, since the marginal cost to produce more oil is less than the price of oil. This will increase the total oil supply (extending the supply curve), and prices will fall the the marginal cost, at which point companies will halt supply expansion.

Are the companies colluding? No. This situation arises from individual companies independently maximizing their profit.

The long-term equilibrium is that the price will be at marginal cost, although the nature of the industry prevents it from responding as quickly to market forces, as, say, bond markets - so there will always be some delay.

Hi Jane:

I re-read Arnold Klein's statement, and I had misinterpreted it completely. My explaination is completely different from his. Sorry for the confusion.

The optimal split between gasoline and diesel production is a function of the characteristics of the crude oil, the specific refinery processing the crude and the demand in the market. Diesel prices increase in the winter because diesel demand is relatively flat and winter demand for #2 fuel oil (which differs from diesel primarily in its paraffin content) adds to the "diesel" demand, shifting the gasoline / diesel split toward diesel, but with an increase in processing costs.

Anybody mentioning price elasticity of demand ? As far as I know my demand for oil is very inelastic: I need to heat my house, I need to drive to work, no a wood stove will not do, no I cannot take my bicycle to get to work. Those who get pushed out of the total demand are those who simply cannot afford the stuff anymore: the poor who cannot affort housing anymore, who cannot affort a job anymore because of rising prices. That is what happening at the demand side, not just taking a few less trips or setting the heating a little lower.

The petroleum industry is not the grocery business with an inventory cycle of days or weeks.

When doing any microeconomic analysis of the petroleum industry, please remember that time horizons are very long term (i.e., inventory cycles of 10-30 years). Over shorter periods, supply is relatively inelastic.

For example, the timeline (i.e. inventory cycle) on exploration project might look like this:

Obtaining exploration rights and permits: 1-5 years;

Preliminary seismic studies: 1-2 years depending on weather and existing infrastructure;

Exploration drilling: 1-3 years depending on seasonal weather conditions and existing transportion infrastructure;

Step-out drilling to prove reserves: 2-3 years deepending on good drilling weather seasons;

Construction of production and transportation infracture to get oil to market: 1-10 years

Actual production: 10-30 years with daily output following the Hubbert Curve, but constrained by transportation thru-put capacity.

I would argue that our current supply constraints are a direct function of investment decisions made in the mid-1980s thru the 1990s which were driven by the collapse in oil prices after 1985.

The current high prices are simply a function of demand finally catching up with supply producing a tight market. This tight market combined with short-term inelasticities of supply and demand will provide speculators a field day since any perceived shift in the supply-demand balance will cause prices to spike.

Solutions are two fold: First, increase supply, which will take years, assuming that the geology will allow it. Second, decrease demand thru conservation over the longer term or, if you want a quick solution, a severe worldwide recession.

We were heading for a petroleum supply-demand squeeze in the late 1990s, but the Asian Currency Crisis and the resulting economic depression in much of Asia solved that problem.

P.S. In this analysis, I am ignoring the debate about "Peak Oil", since it is irrelevant. If the "Peak Oil" thesis is false, we will still be in a tight supply situation for the next decade until new production can be found and brought online. If the "Peak Oil" thesis is true, the tight supply situation would become chronic.

Ann-

There's abundant evidence, and a lot of common sense and academic theory, all pointing in the direction of the market being far more efficient at this than the government.

Government programs have sunk money into initiating new technologies till they were at the point where they could be improved incrementally by a more efficient open market. ARPANET. Numerous products from the space program and defense industries. Computers. etc. were developed and subsidised by government entitities and universities before they were ready for the market.

Japan's economy, which heavily subsidises its corporate tech development, is a better example of gov't assisted research than Mao.

The Great Leap Forward as a representative for technology subsidization is like using the American Great Depression as a model for capitalism.

As for subsidizing buses and other public transportation - I think they're already pretty heavily subsidized.

So are airplanes. So are cars. Perhaps we should quit building and maintaining the nation's roads using government funds. Perhaps we should quit using eminent domain to seize new land for them and see what kind of truly market-based solution results? When I lived overseas in asia, many people didn't have cars so their transportation and their stores were set up to accomodate that. In America, people have cars. Because of that you get urban sprawl and cars become a necessity.

Last time I looked into the situation in NJ, gasoline taxes and registration fees exceeded the cost of building and maintaining roads, while mass transit got only 40% of its cost from fares. Car drivers were massively subsidizing mass transit (which only carried 4% of the population).

Japan's MITI must have done a great job for the Japanese economy - it has only taken Japan 16 years to shake off its economic doldrums.

The greater the number of comments, the further from the original question. Sorry.

Arnold and John Thacker got it.

Oil is a fantastic example of what a supply curve really represents. A certain quanity of oil can be profitably produced at $20. If demand grows beyond that we have to let prices go to a higher level -- say #30 -- so oil that is more expensive to produce can be drawn into the market profitably. As demand grows this process is repeated so that more expensive to produce oil can be brought to market -- that additional oil is the marginal supply.

When oil is $50 the firm that owns oil that can be produced for $20, $30, $40, etc.. earns great profits. This is actually the way the system is suppose to work. the profits go to the firm that has the expertise and experience to best expand supply. Moreover, the profits are the steering wheel of the capitalist system and serves to signal other capitalist to send additional capital into the industry earnings high profits.

Interestingly, when you look at it this way you can understand how the price controls imposed by Nixon in the 1970s worked and how they actually lead to a greater supply and did not play a significant role in the 1979 gas lines. The 1970s price controls were only on Tier I oil -- domestic oil wells already in existence when the price controls were imposed. Their were no price controls on Tier II oil -- new wells or imported oil. Technically, some old preexistent oil wells could be shifted to Tier II oil if you could demonstrate a need to inject or other wise spend more to keep production high. But oil companies could no longer increase profits by raising the price of Tier I oil. Consequently, the best way to increase profits would be to drill new wells. So the price controls in a period of higher prices actually lead to a massive oil exploration boom -- for example in 1979-80 the rig count reached 4,000 -- almost double its prior peak. Domestic oil production peaked in 1969, and the only time since then that it grew was during the period when price controls and/or the windfall profits tax created an artifical incentive for drilling.
The final element to this story is that when
Reagan finally ended the price controls and the artifical incentives disappeared the domestic exploration boom collapsed -- the rig count fell to around 1,000.

The artificial incentives of the price controls- windfall profits tax created such a massive over investment boom and excess capacity that it took some 20 years to work it off and we are just now
coming out of the other end of that era of excess capacity, low prices, and low capital spending.

-- Politicians, oil company executives, and lobyiest are not stupid and they often pass legislation or rules that on the surface appear to create one set of incentives, but when you look at the details you find that the truth is quite different -- ask any tax attorney.

The perceived future price of oil has steadily increased. This encourages most producers to charge more today and preserve their supply for later, when prices increase even further.

To add to Arnold -

Only long run profits (including of course a nomral return on capital) have to be driven to zero in a competitive market.

If you believe there are demand side fluctuations then it is possible that there can be predictable and persistent high profits, so long as there are predictable and persistent low profits (economic losses).

And as an aside to (A)

I certainly see price induced rationing were I live. The ratio of compacts to SUVs in store parking lots as risen substationally. I think that at least a few people are leaving the Tahoe at home.

Re: Zero rationing can only occur if the good is available in infinite supply at zero price (e.g.: information).
Posted by Noah Yetter at April 28, 2006 03:31 PM

Are you kidding me? Parties pay for information in many many many markets.

Spencer: "But oil companies could no longer increase profits by raising the price of Tier I oil [from existing wells]. Consequently, the best way to increase profits would be to drill new wells."

What the oil companies learned from that was that the best way to increase profits in the future was to wait until there was a crisis and oil prices from existing wells were capped, and only then start drilling new wells - which takes years.

Silly me, I was wondering why no oil company ever anticipates a coming crunch by increasing capacity first, and thereby having more oil to sell at a higher price.

Tunda, Noah: How about we rephrase that as: "Zero rationing can only occur if the good is available in infinite supply at no marginal increase in cost." This describes information products: Every additional million disks made and sold (if there's that much demand without more advertising) costs the seller the same as or less than the preceding million.

Oh, you could theoretically run out of acrylic or hit the maximum capacity for the disk pressing plants, but in the real world, shortages of an information product on the market are either deliberately induced to hype the price higher, or temporary shortages due to not ordering enough ahead.

Ryan -

My point using Mao and the Great Leap is that there's greater risk, due to lack of diversification, when the government forces everyone to follow one path, rather than allowing a multitude of approaches chosen by those with an incentive to find the best answer. Mao had his ego bound up in sticking to his 'solutions' and was willing to kill large numbers of people, rather than admit that he was mistaken. Yes, it's an extreme, which is why I thought it illustrated the point well. If everyone is forced to follow one and only one policy, there can be big trouble if that policy doesn't work.

But you're right that Japan is another good example. By forcing capital to go into only a few hand-picked industries, they've developed those industries at the expense of the overall economy. The main reason that those industries are so advanced, while the rest of the Japanese economy is still lagging (for example, Japanese banking and retailing is hardly world-class), is because the favored industries were forced to export. Even though they were carefully shielded from competition and guaranteed excessively cheap capital at home, they were still forced to compete abroad, providing discipline.

As Rich Berger pointed out, Japan's decade and a half of stagnation doesn't fit well with your claim of the fool-proof brilliance of central government planning. Japan overall would have been much better off if they'd found a less centralized, bureaucratic approach that didn't excessively favor some industries at the expense of others, and if they'd focused on setting reasonable rules for competition rather than picking winners and losers. The MITI example isn't as dramatic as the Mao example, but it works in the same overall direction.

A case can be made for government to help fund some basic research temporarily, and it's certainly possible for those investments to work out well, ex post, in some cases. But in this case, the rewards to finding alternative energy sources are huge (unless the political vultures pounce on the industry and windfall-profit-tax it to death). High prices will lead to market solutions. I trust individual greed and creativity to come up with a solution, rather than trusting power-hungry politicians that have no idea what they're doing and primarily want to find the solution that sounds best, regardless of whether it will actually work.

Markem said --Silly me, I was wondering why no oil company ever anticipates a coming crunch by increasing capacity first, and thereby having more oil to sell at a higher price.

The answer is very simple. If the oil company anticipated the coming crunch and increased capacity and so had more oil to sell the crunch would never arrive because of the very actions of the oil company to increase supply.

If the market price is $20 it is extremely unlikely that oil companies will bring on much additional oil supplies if the marginal price of that oil is $30.

Essentially every major oil company uses some combination of lagged oil prices in its planning and budgeting for new drilling. Even now most drilling budgets are based on the assumption of something like $25 oil.

In the early 1970s the marginal source of oil was the North Slope and the North Sea. So as investors we assumed that the price of oil would have to rise to the point that would make development of the North Slope and the North Sea profitable. No oil company was going to spend $10/ bbl to bring on those sources of oil as long as the price of oil was $2/bbl.

While there is no doubt that Japan has struggled the last 15 years, we can't forget the previous 40 years of essentially uninterruped growth. Is Japans growth over the years after the war the greatest success story ever? It might be - still the second largest economy in the world, even after 15 years of stagnation. Look at Korea, with essentially the same system, a huge success. We can blame them for being inflexible, but Korea went from something closer to the stone age to a modern society in 40 years, as a result of the very style of controlled capitalism you despise. China is doing the same thing right now. Its not foolproof, and it has huge flaws, but it is a proven method of rapid and spectacular growth. I find it hard to knock as a method of moving from $50/year to $25K/year GDP/capita. Oh, its got flaws...

I think any game theory people should be able to come up with a good 'prisoners dilemma' solution to oil prices and profits, where a defector reduces his utility. Why hasn't anyone defected?

Also, the price of oil in 1998 was $12 a barrel, so in 2001, risk managers wouldn't agree to new capacity. No incentive in it, and a free call option on your current production capabilities. Worst case scenario of not increasing production? Massive profits.

"Last time I looked into the situation in NJ, gasoline taxes and registration fees exceeded the cost of building and maintaining roads, while mass transit got only 40% of its cost from fares. Car drivers were massively subsidizing mass transit (which only carried 4% of the population)"

Now they roads do. It is unlikely that this was always the case. And after a few decades of takings for highways and roads, all of the takings are forgotten, all of that appropriated real estate just buried.

If oil goes up to $100 a barrel, I don't think that all of those years of oil and gas subsidies and having taxes pay for roads is going to seem quite as cheap. $100 a barrel will change it. I think we will see $60 even $50 first, but its coming.

Spencer: One oil company by itself couldn't develop enough new capacity to do more than slightly blunt the shortage and price spike that's coming - and they'd be making huge profits if they had extra oil to sell going into the crunch. Except that they've now learned not to do this, because the "windfall profits" will be taken away from them.

When the government stays out of the market, severe shortages and price spikes only happen when something really unexpected happens (these gasoline shortages are NOT unexpected), and even then it generally isn't a 2 or 3 times price rise as has happened repeatedly with gasoline.

Here in the real world, the talk of "windfall profits taxes" has already scared the oil companies and will inevitably lead to less production. My employers sells durable goods to oil extraction and refining companies (notably the Canadian tar sands). Incoming orders have fallen off in the last four weeks; according to the salesmen, their oil company contacts are already cutting back on purchases of pump parts and new refining equipment because "what the heck,
if we make more profit, the government is only going to take it away." This is an "at the margin" effect due to just talk. Imagine what will happen if confiscation becomes reality.

The comments on rationing remind me of when I was younger and was at Disney World with my girlfriend and was just starting to understand economics a little and she asked me how the average family could afford to stay at a hotel on the Disney property and I told her that there was limited land on the Disney property and so there had to be some way to decide who gets to stay there and it was decided by who would pay the most and the poor people could stay in Kissimee and then she had a headache for the rest of the trip.

"the very style of controlled capitalism you despise"

I don't despise the path of Japan and South Korea, but I think that Taiwan and Hong Kong are better role models. Given the threat of attack that Taiwan has always been under, it's economy has been amazing. Their flexibility has been due in part to not facing the added risk of the government forcing everyone to in the same direction. But I would much prefer to see, say, Zimbabwe follow in the footsteps of Japan and South Korea, rather than self-destructing.

China loves the examples of Japan, South Korea and even Singapore, which supposedly prove that governments can interfere whenever they feel like it, but China isn't following those examples whole-heartedly. The whole "with Chinese characteristics" exemption is based on the idea that they're unique and thus shouldn't have to learn from anyone else. Their official policy is 'crossing the river by feeling for stones', i.e. no plan, no thinking ahead, just take one step at a time and see what they feel like doing next.

And what is it that communist party control freaks consistently feel like doing? Throwing their weight around whenever it's convenient. Their success so far is largely due to the fact that they're too incompetent and behind the times to actually keep a tight grip on everything.

So the price controls in a period of higher prices actually lead to a massive oil exploration boom -- for example in 1979-80 the rig count reached 4,000 -- almost double its prior peak.

Wow - up until now I had thought that high prices led to the exploration boom. And here it turns out that the price controls did.

Yeah, right. The price controls were a taking, that had nothing to do with the exploration, at best having not prevented the exploration. In my humble opinion, of course.

for example in 1979-80 the rig count reached 4,000 Why 1979-1980? There'd been a severe shortage and price controls since 1973.

The boom of the late 1970's led to a glut in the the early 80's. During that glut, so many small oil outfits went bankrupt that the savings and loans industry almost went down with them. And of course this stopped most exploration, leading to shortages later... If government action contributed to this cycle, it certainly wasn't helping the general public. (It's likely it did help those who were both government and oil company insiders, like GHW Bush, who could learn what new regulations were coming in time to arrange to profit from them.)

Oil companies have fixed costs and variable costs. Their fixed costs make up the bulk of their overall costs. Let's say that until oil is $25/barrel, these companies don't make a dime. However, after that level, almost all of their revenue profit. Their marginal costs are very small.

Beyond that, it is implicit collusion. They're not going to drop their prices at the pump, because nearly half of the price is taxes, refining, and distribution. The oil companies have little control over that. So if they drop price, it is all profit they're taking away from themselves and it is only 50% effective.

In the end, supply and demand forces will push prices higher. The best way to combat it is to eliminate the 45 cents per gallon tax that is charged to everyone.

MARKUM -- Just to provide you with a few facts .
The rig count actually bottomed in 1971 and rose at a 13% average annual rate of growth thru 1980.

why don't you go to the dept of energy and look at a few facts so you could actually make an intelligent argument and make people think you might actually know something.

"all demand is still being met, i.e. no rationing is occurring (via the price system or otherwise, as far as anyone can tell, there's no evidence of inability to meet all the demand that would exist at the lower price)"

This has probably been pointed out, but I can't resist. The fact that "all demand" is being met, which I take to mean demand=supply, does NOT mean that there is no rationing.

The demand for oil and gasoline in the short-term is somewhat inelastic, which means that prices will rise quickly without very much change in equillibrium quantity. Because of this inelasticity, in order for rationing to occur the price must change a great deal for a relatively small change in quantity demanded (or supplied).

The short answer is that demand and supply are relatively fixed in the short run (for oil) so that large price increases are required to induce small changes in quanitity demanded (or supplied).

The longer time passes, the more this will change. Consumers will buy new cars, move closer, or carpool, decreasing demand and lowering price. Supply will increase as new sources of oil become economically viable, decreasing price.

Economic supply/demand gymnastics aside - - If my oil company can double profits over last year, absent collusion, instead might I not settle for a 75% profit increase and grab some market share from my competitors by undercutting price??? In fact, if I won the market share, I might still get that doubling of profits!

Economic supply/demand gymnastics aside - - If my oil company can double profits over last year, absent collusion, instead might I not settle for a 75% profit increase and grab some market share from my competitors by undercutting price??? In fact, if I won the market share, I might still get that doubling of profits!

You misunderstand. The price is where it is largely because demand is high and supply is limited (although commodities speculation has possibly driven it beyond the real market rate). At $70/barrel, everyone with a well is pumping as furiously as they can short of overproducing and causing wells to collapse prematurely. The windfall profits might well drive additional supplies into the market, but that has a leadtime measured in years.

In other words, to try and "undercut" others would be stupidity in action. There is no significant surplus supply to draw from and no way to capture customer loyalty, so all you would cut is your profits.

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