Funmurphys: the Blog

Oil Economics 101

Since Jane Galt is tackling abortion at the moment, I'm going to seize the opportunity to talk about the Senate hearings on oil prices. I suppose the whole thing is one of those moments that Yakov Smirnoff loves -- only in America are private companies called in to explain why in a capitalist system they are making the huge, windfall profit of a whopping 10 percent. The really sad thing is that I, with but one college economics course under my belt understand economics more than our august Senators do (at least some of them, anyway). Or perhaps its that they understand politics far better than economics.

It continues to astound me how people confuse cost and price. The price is what the buyer pays, and cost is the aggregate of the sellers expenses for a given transaction. Profit (or loss) is the difference between the two. The real beauty is that there are least two ways to figure cost -- average or marginal -- but only one way on price. And you can play all kinds of un games by picking and choosing which basis to determine cost.

Now the funny thing is, back when I learned my economics (1983) -- and from a marxist, no less -- they taught that price is set by the intersection of supply and demand curves, as illustrated here. Cost enters in through the back door, as it is part of the supply curve. So let's review - if demand goes up (shifts to the right), the price will go up, but then so does the quantity sold. And if supply goes down (shifts to the left), price goes up, but the quantity sold goes down. Wow, cutting edge economics, only formulated this way for 115 years.

Now pay close attention here, the price changes as rapidly as the change in supply and/or demand, even nearly instantaneously. There's no wait to change for a given product, made at a particular price point, to eventually make it's way all the way through the distribution system to the final consumer. So if for instance a hurricane roars through the Gulf of Mexico overnight and decreases the supply of oil overnight, why the price changes overnight too! Wow, no government price board meets to make it happen, the market simply reacts to the new information. Maybe more countries should use that market thingy.

Permit me a small digression [OK, I've come back from the bottom of the paragraph and it turns out that this is really a great big digression, but its a good one, so stay with it] here, because I know a little something about control theory (OK, a lot more than I know about economics). And if you're into controls, lag is your enemy. You hate lag. Lag screws up your system. Lag can make your system go unstable, lag is something you would like to eliminate completely if you could. Except, then setting up real world control systems would be too easy, and you wouldn't get paid the big bucks to do it, so OK, you love lag, because lag makes your genius necessary. But say I'm a user of a controlled system, then lags my enemy. For all the reasons I cited above, only now I'd just as soon have geniuses working other problems so I don't even have that incentive. The market is simply a control system for economic activity. One big reason it's better than any other method so far devised, is that it is less laggy than the other systems (such as government control). What is one of the things businesses hope for when they flatten their management structure or better integrate different parts of the enterprise? They are trying to reduce lag inside their own control system - vertically and horizontally. So the ability to make rapid price adjustments isn't a bug, it's a feature, and a very important one at that. It means economies can turn on a dime, and not keep overproducing unwanted products and services and fail to produce wanted products and services. One of the reasons improved information technology has helped the ecomony is that it has wrung lag out all over the system. OK, enough about lag, but once you understand control theory, you'll laugh when Princeton economics professors write columns for newspapers saying the worry that increased informational speed and flow could destabilize an economy, and you'll laugh because they got it exactly wrong, and you don't even have a big pointy head.

Another great thing about the market is that in a transparent, open economy we're all colluding together to get what we want, when we want it, where we want it. We all contribute to setting the price and the quantity of each and every good and service out there. We even stimulate the formulation of brand new goods and services. Wow. The amazing thing about price is not only is it feedback from the customer to the producer, it's feedfoward from the producer to the customer.

OK, back to the oil companies. So what do higher prices and higher profits tell us, hopefully including the oil companies. To the oil companies, it says produce more oill!!! That's what it says. And while it's telling the companies that, its actually giving them the money to do it with. Wow. You get told what to do and you get the resources to do it with. But wait, there's more. Because to us consumers, it's saying cut back on oil consumption!!! because there is a greater reward for it than there was before the price went up. Or we could wait for Congress to pass a sense of the Congress resolution that the oil companies should produce more and consumers consume less, and then pass some legislation to give companies incentives to produce and consumers not to consume, and by the time that all happens, we'll be in the middle of an oil glut. See why lag is bad?

So why is it so hard, absent hurricanes and other natural disasters, to figure out the gyrations of gas prices. Because from where you sit, you can't see the supply and demand. You're driving down the road thinking everybody I know is driving just as much, so why does the price go up and down all the time? Energy markets are global, so the whole world is setting the price. So changes in global supply and demand drive the price at your corner gas station. I suppose that's one opposition to globalization - since we can't see the inputs (supply and demand), we distrust the output (price).