What We Didn't Learn in Economics 101
I published the following piece in November 2008 on my now defunct pre-Ricochet blog. It seems timely to revisit the post, particularly the penultimate paragraph, given the current kerfuffle over presidential hopeful Michele Bachmann's promise to reduce gasoline prices to $2 per gallon.
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Remember this scene from the summer of 2008? Gas prices in the SF Bay Are are now as low as $2.35 per gallon.
Have you noticed what’s happened to the price of gasoline lately? Why is the cost of a gallon of fuel dropping so rapidly? Perhaps oil futures traders, aka greedy speculators, are less greedy now. Perhaps last summer’s congressional hearings featuring “Big Oil” CEOs are having a dramatic, though considerably delayed, effect. Perhaps. Or maybe conspiracy theories are overrated and market forces actually determine the price of a commodity like gasoline.
I’ve taken my share of economics courses, starting with an introductory class as an undergraduate and, a decade later, advanced offerings as an MBA student. Like many of you, my eyes glazed over in Econ 101 as the professor droned about supply and demand functions, price elasticity, market equilibrium and the rest. You know what? I should have paid closer attention, and you should have listened too, because this supply-demand stuff works.
Many otherwise intelligent folks go loopy when the topic turns to economics. They seem to
believe that the prices we pay for goods and services are set, not by the market, but by corporate villains like The Simpsons'Mr. Burns. Perhaps, like me, they slept in that introductory econ class. Consider that just last summer I got into a row with the normally sensible Aircraft Owners and Pilots Association – I'm a private pilot – after AOPA signed on to Stop Oil Speculation Now, a conspiracy-theory organization promoting the idea that high gas prices are caused by runaway oil commodities trading, not fundamentals of supply and demand. I wrote to AOPA pointing out the economic illiteracy of this reasoning, but got nowhere.
I believe that SOS Now's actual purpose is to counter public pressure to unlock currently off-limits oil and shale producing regions of the US to energy exploration and development. In the end, SOS Now failed to achieve its stated aim of reforming commodities trading practices, but it did divert public attention from the actual drivers of gasoline price escalation in the run-up to the presidential election.
So why were oil prices going up like a space shuttle launch last summer and falling like a rock today? I’m afraid we have to look at those long-forgotten supply-demand curves.
Consider the graph above. The quantity supplied is on the horizontal, or X-axis and the price on the vertical Y-axis. The relationship above describes a classic case with constant supply and demand functions. As the price offered for a product increases, suppliers are willing to provide more of it, hence the upward slope of the supply function as one progresses along the X axis. It makes sense that suppliers are willing to sell more in response to a higher price. Demand works in opposite fashion. The downward sloping demand function reflects a buyer's propensity to want little at a high price but progressively more as price goes down. Where the two relationships intersect, buyers' propensity to buy and sellers' propensity to sell match up and we have the market-clearing equilibrium price.
Supply and demand functions vary in shape and angle for different products, and the relationship only holds in the short run when the market is at equilibrium. In the longer term, the supply and demand functions can shift. For example, the demand relationship for lamp oil shifted dramatically down and to the left after the advent of electric lighting: consumers wanted to buy much less lamp oil no matter what price it was offered for; you could hardly give the stuff away. Similarly, the demand relationship for gasoline shifted up and to the right after the use of automobiles became widespread. Over time, a new supply relationship developed, shifting the supply curve rightward as new production was brought on line in a longer-term response to rising demand.
The "Drill Baby Drill" advocates intuit the meaning of the above graph from that long ago Econ 101 class. As you can see, if additional supply is brought on line through additional oil drilling and refinery construction, the supply function shifts rightward. Assuming the demand function stays the same, meaning that consumers are equally interested in purchasing fuel at a given price, then more fuel is provided at a lower price (the P2 - Q2 point on the graph versus the original P1 - Q1 equilibrium).
The curve above more realistically reflects the dynamics of short-run gasoline supply and demand than the general textbook case. The fixed costs of setting up oil wells and refineries are enormous, but the incremental costs of extracting or processing a bit more fuel are low, up to a point. Therefore, as demand increases, prices rise only modestly along the flat portion of the curve. However, at some point a bottleneck develops -- extraction, refining or transportation hits the wall in terms of additional capacity -- and even a slight rightward demand shift results in a dramatic increase in the price of fuel.
Drilling advocates during the 2008 summer oil-price spike proposed that Congress remove the legal barriers preventing any domestically generated rightward shift of the oil supply curve. Given increasing demand with global population and economic growth (rightward shift of the demand curve) and gradual reduction in supply with depletion of existing oil fields (leftward shift of the supply curve), continued high gasoline prices seemed inevitable without action on the supply side.
Despite all the grandstanding on TV about oil speculation and malignant CEOs, the sad truth seems to be that congressional liberals actually support soaring fuel prices; usually without saying so explicitly, for obvious political reasons. Alternative energy sources are simply not cost-competitive with fossil fuels unless gasoline prices remain significantly more expensive than the summer 2008 peak. As you might expect, environmental activists and greentech financiers are key consituencies favoring a continuing leftward drift of the oil supply curve.
Prices have come down of late not because of any change in the supply curve, but because demand has decreased. The credit crunch and attendant recession have structurally reduced global oil demand: Consumers and businesses want to buy less fuel now at any particular price. Graphically, the demand curve has jumped to the left. Since the old equilibrium was along the near-vertical portion of the oil supply curve, this evolving leftward demand shift is driving the now plummeting price of fuel.
In a sane world, our political representatives would take the current declining price environment as a window-of-opportunity to remove the shackles from oil exploration and production, thereby allowing producers to begin the long lead-time capital investments required to shift the oil supply curve to the right. Given the current Democratic advantage in Congress, the more likely legislative impulse will be to mutter darkly about the need to prevent future Wall Street greed from pushing oil prices up, while doing nothing at all to permit supply to increase.
One day the world economy will recover, the oil demand curve will shift rightward into the steep part of the supply curve and gasoline prices will once again soar at a stratospheric rate. I bet that when that day arrives our president and congressional representatives will act on the confident assumption that we slept through Econ 101.
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Dec '10
Re: What We Didn't Learn in Economics 101
Obama said explicitly to the editorial board of the SF Chronicle that he supports soaring costs of energy. Under his preferred carbon tax policy, he said, "electricity rates would necessarily skyrocket."
With drilling in the Gulf of Mexico hampered by the Administrations slow pace of permitting, with major areas of the continental shelf off-limits to exploration and development, with so much energy buried on lands subject to Federal restrictions and moratoria, the question isn't how we get to $2 gasoline but why we tolerate the Obama Administration doing its level best to push us towards $5 gasoline.
Dec '10
Re: What We Didn't Learn in Economics 101
George, very nice! Everyone at Ricochet should study this post - it's how free markets work. A free market economy is the sum of billions of these kinds of decisions and interactions freely made by individuals and organizations every minute of the day.
This is why centrally planned/statist economies are hopelessly incapable of economic prosperity. Technocrats, whether central planners or regulators, have no way to even begin to understand the complexity of the billions of interactions and decisions that occur each day in the market place - represented by their various supply and demand relationships. Which is also why the careful planning and targeted market interference of the "managerial progressives" like Romney always ends with economic misery. Central planners, statists and managerial progressives all believe technocrats can administratively manage the millions of supply-demand curves which represent individual decisions and actions of the market - technocrats do this by replacing the supply and demand relationships established by the market with their own "enlightened" relationships - the result is always the same, the endless stupidities of unintended consequences.
Edited on Aug 18, 2011 at 6:29pmMay '10
Re: What We Didn't Learn in Economics 101
Great. Now look again at that first picture and explain why gasoline providers are the only companies in America who can charge a tenth of a penny.
Seriously, how did that get started? And why did people put up with it?
Jul '10
Re: What We Didn't Learn in Economics 101
George, aren't speculators part of the increase in demand? They're not the sole reason, and not even the dominant factor given an industrializing China and India increasing their demand, but they would still be an increase on demand. That makes them easy targets for people not versed in the supply and demand for oil. I think it would strengthen the argument to concede speculators do increase demand, but that it is inconsequential compared to the increase in demand from industrializing countries. Not to say you're denying speculators have any impact, but I have seen that argument from some quarters. Your prescriptions for moving the Supply curve are perfect and exactly the kind of policies we should be pursuing.
Dec '10
Re: What We Didn't Learn in Economics 101
By speculators, do you mean the Futures Market?
Jul '10
Re: What We Didn't Learn in Economics 101
jetstream
By speculators, do you mean the Futures Market? · Aug 18 at 7:05pm
I was of the impression that's what was understood, but is that not always the case?
Re: What We Didn't Learn in Economics 101
"Speculators" don't affect oil demand at all. Not one bit. Traders bet on future prices and thereby allow other market participants to hedge the price they will pay or receive in the future. This creates certainty for, say, Southwest Airlines' fuel budget. But the commodities trader isn't burning any additional oil as a result of his activities. Not a drop.
Traders perform an important function by ensuring that the market reflects expected future developments today.
Incidentally, this is why fuel prices drop immediately upon expected future developments such as currently decelerating economic activity...or an expected future increase in production.
Dec '10
Re: What We Didn't Learn in Economics 101
Whiskey Sam
jetstream
By speculators, do you mean the Futures Market? · Aug 18 at 7:05pm
I was of the impression that's what was understood, but is that not always the case? · Aug 18 at 7:14pm
Whiskey, the Futures Market doesn't change demand for a commodity. Futures dampen large price fluctuations because of big spikes or sharp declines in demand. It provides for both speculation and hedging of future commodity prices. Futures also add liquidity to the markets.
Jul '10
Re: What We Didn't Learn in Economics 101
That entirely depends on whether the speculator is taking possession of the oil and removing it from the market, even temporarily. There's no evidence this is happening enough to impact the market (if at all), but I'd rather admit there is a possibility and point out either its lack of evidence or lack of impact and require the Dems to support their assertions with proof than dismiss it out of hand.
Edit: I'm reluctant to say speculators have no impact when even people involved in the futures market believe their actions are adding a fear premium and driving up the price unnecessarily. Link
Edited on Aug 18, 2011 at 8:33pmJun '11
Re: What We Didn't Learn in Economics 101
An interesting comparison here is between the chart of the XOI vs. the GLD. What is the XOI saying about the strength of the economy? What is the GLD saying as it moves up into a parabolic curve which cannot be sustained?
Trees don't grow to the sky. Sell gold. As the shoe drops here (and in the upcoming days and weeks it is going to get scary. There are going to be high profile European bank failures), get long good, old fashioned American growth.
Dow 20,000 within 5 years. Hands down.
Jun '11
Re: What We Didn't Learn in Economics 101
And B.T.W..... that you reference the Simpsons in your post betrays your good taste and sense of geometry. Only a South Park reference is missing. Kudos.
Re: What We Didn't Learn in Economics 101
Maybe I need my own post on this, but it would make two points: First, that speculators do affect current demand. If you think the price of oil will rise tomorrow, you demand more today. Future prices are also part of current supply: If I can sell oil for more tomorrow I withhold oil today. (Here's the story in the opposite direction, from 2009.)
Second, to your last graph George, you should draw both the short- and long-run supply curves. The long-run curve will be flatter. If the demand curve is inelastic (evidence says it is) the long-run effect on prices will be to decrease prices more in the long- than short-run. To $2? Hell if I know, and I don't believe Rep Bachmann does either. And I am not enough of an energy expert to say how long the long-run is. But assuredly, it will fall more in the long run, and the change is going to be significant because of the inelasticity of demand.
Jul '10
Re: What We Didn't Learn in Economics 101
King, is the article you linked to at all related to this case where the CFTC has charged Parnon Energy and Arcadia with price manipulation?
Re: What We Didn't Learn in Economics 101
King, thank you for joining the thread. It's great to have a real economist to confer with.
I appreciate your point that long-run effects will outweigh short-run. I guess I get carried away rebutting the received wisdom that there can be no short-run effect whatever.
I understand the opportunity to influence short-term price fluctuations through the futures market. But isn't this a very short-term phenomenon?
Producers can just "store" their oil in the ground. But traders aren't producers. The amount of future production available for purchase is limited. And once the oil is pumped, it is either in storage, in transit or in the process of being consumed. Since traders don't increase consumption, anyone betting long has to pay for scarce storage. And with world demand running at 85 million barrels per day, storing a significant fraction seems impractical, not to mention incredibly expensive if prices begin moving against expectation.
Your thoughts?
Edited on Aug 18, 2011 at 9:40pmDec '10
Re: What We Didn't Learn in Economics 101
George, off topic, if you don't mind talking about it, I was curious what kind of airplane you fly. Until a couple of years ago, we were putzing around in a Beechcraft Baron 58P. Beechcraft are such a pleasure to fly, whether Bonanza or King Air the only real difference is the number of power levers and approach speeds.
After the government began promoting public muggings at airports, we migrated to a Cessna 414 with a RAM conversion. It's comfortable enough to go anywhere in North America, which makes the TSA just a bad rumor. Now if there were just some way to hit a tanker over the Atlantic then travel to Europe could be a mugger free experience :-)
You know, if the AOPA is able to gin up enough government interference in the Avgas market and gets everyone $10 or $15/gal Avgas ... turbines and kerosine might be the only reasonable option.
Edited on Aug 19, 2011 at 11:47amAug '10
Re: What We Didn't Learn in Economics 101
You knocked that one out of the park, George.
Speculation does affect the current price, however. That's why it's valuable - if the futures price represents our best estimate of the future relationship between supply and demand, then pushing prices in that direction now helps to cushion the market from supply and demand shocks. If we know that a commodity will be more scarce in ten years, it is completely rational to charge more for it now.
But speculating in commodities is not like dealing in credit swaps or mortgage-backed securities. When you buy commodities futures you're buying a real contract that expects you to take future delivery. At some point you have to float a ship up to the docks and start pumping oil. That limits the size of the market and prevents runaway speculation.
Re: What We Didn't Learn in Economics 101
Whiskey, the case I thought of was in 2009, not 2008 as in that one you linked.
George, depending on oil prices, tanker storage can be economically efficient as an alternative to storage on-shore. Not a whole lot -- maybe two days' supply -- but given inelastic demand, you don't have to pull much off of supply to get a significant move in the spot price. In oil economics circles this is known as contango and its opposite, backwardation. See Investopedia.
I find it interesting that while the MSM understands the limits of executive power on oil prices it still seems to think fiscal policy can make unemployment disappear magically. If we took the same level of understanding of oil markets to labor markets, maybe we'd get better policies: Maybe we'd get the same humility from White Houses in the future over the state of the economy as a whole as her critics think Bachmann should have over oil.
Dec '10
Re: What We Didn't Learn in Economics 101
Dec '10
Re: What We Didn't Learn in Economics 101
King Banaian:
... I find it interesting that while the MSM understands the limits of executive power on oil prices it still seems to think fiscal policy can make unemployment disappear magically ...
... and no amount of real world experience, results, data ... will inform them of their error. The corollary is an avalanche of suffocating, poisonous regulations and macro-economic policies can't possibly be at fault for a continuously deteriorating economy. Even after the mass of poisonous macro-policies has reached the amount to collapse the economy into a smoldering black hole, the MSM and Democrats will describe it as bad luck. · Aug 18 at 10:37pm
Sep '10
Re: What We Didn't Learn in Economics 101
King Banaian:
. But assuredly, it will fall more in the long run, and the change is going to be significant because of the inelasticity of demand. · Aug 18 at 8:06pm
Are you saying demand for oil when the growth rate is 7% is the same as when the growth rate is 2%? What do you mean it is inelastic? While supply disruptions account for various spikes in prices the elasticity of demand primarily caused the drop from 140 - 40.