From my experience sending out political emails, I understand the value of a catchy subject line, or in this case a catchy post title. I could have used a title like "laissez-faire economics", which is sort of what this post is about, but then you would have ignored it and signed on to facebook, and now here you are!
Everyone's heard of Adam Smith's famous 'invisible hand', a metaphor for the theory that society's best allocation of resources will be achieved by everyone pursuing their own individual self-interest in a marketplace. Why then, are firms necessary? If individuals can go to the market to get everything they need, why do they become involved with firms? If you think about it, firms are organized in the exact way--centralized, planned, authoritarian--that is rejected by the invisible hand. It's a question that The Economist takes on. The answer, they argue, is due to the high transaction costs associated with going to market, as well as the collective expertise that can be achieved by a company of people.
It's the same reason you join any group--to be more successful than you could be on your own. If you are a great baker but aren't good at accounting, you might want to become part of a bakery so that you can focus on baking and they can keep track of how many people buy your snickerdoodles. If you are a commercial airline pilot, you need to become part of a firm so they can buy the plane you fly, attract the customers that need you to fly them somewhere, and negotiate with the government to make sure you don't fly in restricted airspace.
I'm reminded of a scene in The Beautiful Mind, the movie about the Nobel-Prize winning economist John Nash. In the movie, Nash comes to his breakthrough idea when a group of young women walk into the bar, with one of the women being the most attractive:
For the purposes of our little discussion here, let's call this super-hot woman "Hillary Clinton". The invisible hand would predict that all the guys would hit on Hillary. But Nash reasons that if everyone tries to impress Hillary, only 1 guy could potentially attract her, leaving the loser guys with no girlfriend. And the loser guys would not be able to hit on Hillary's friends, because Hillary's friends are offended that they weren't the original target of the guys' affection. So in Adam Smith's scenario one guy wins and the others lose. Nash reasons that the best outcome is for all the guys to go after Hillary's friends--and not Hillary at all! At least then, all the guys would have a girlfriend, even know nobody would be dating a supermodel. "Adam Smith was wrong", the Nash character announces to his confused friends as he passes by all the Hillarys in the bar to go back and develop his theory.
In both the example of the firm and the 'non-cooperative games' to which Nash's theory is referred, Adam Smith's theory shows some weakness. As an undergraduate economics student, I was forced to tattoo Adam Smith's name on my left bicep as a show of appreciation for the so-called father of economics. "How could he be wrong?", I wondered, a foray into philosophy that was surely a result of a hangover and daydreaming during a class I really didn't care about. I asked this guy, who was my faculty mentor, and remains the smartest person I think I've ever met. The brilliant power of Adam Smith, he advised, was that despite a couple scratches on the fender, the Smith-mobile is still driving in the fast lane. (We're using a car metaphor now--try and keep up!). Despite the odd theory or exception now and then, it still remains mostly true that the best outcome is achieved by everybody doing what's best for them in a market free of coercion.
Taking the position that we are free-market experts, economists from the Chicago School argue that humans are 'economic robots'--that every decision they make is the result of the analysis of all available data related to the transaction. This of course is not possible--most people can't know if a cotton shirt at Target is cheaper than one at Walmart--but you will try! Maybe you ask your friends that shop at both places; maybe you know that milk is cheaper at one place than the other and you assume that all prices at that place are cheaper; maybe you're rich and you hire a private shopper to investigate and get you the best price. In any case, the Chicago school model still might be the best model to use because it just might be the best predictor of what you're going to do.
Free-Market advocates don't have to worry--there is still room on your right bicep for Hillary's initials tattooed inside a heart.
Showing posts with label free market. Show all posts
Showing posts with label free market. Show all posts
Thursday, December 23, 2010
Thursday, June 4, 2009
Letters To The Editor!
One of my favorite blog formats involves letters to the editor, generally submitted to The Capital. I reproduce the text of the letter, then provide accurate, witty, and insightful commentary in response to the points the letter writers are trying to make. The benefits of such are a format are twofold:
1. I can engage in a debate without giving the person I am debating a chance to respond, which makes it much less stressful for me.
2. Letter writers feel compelled to write about a variety of issues, which gives me the chance to comment on many issues that would otherwise be irrelevant.
Today, we have 2 letters. Let's begin!
I noticed gasoline prices are slowly climbing up again, a few cents more every few days.
I recently noticed Mrs. Politics was slowly taking more and more pennies out of my piggy bank, but you don't see me complaining.
On Sunday night the gasoline was $2.39 and on Monday morning the same gas station had changed it to $2.45. I cannot understand why gasoline would go up from a Sunday night to a Monday morning by 6 cents.
I have a bad feeling about where this letter is going. As one former Ward 1 Alderman infamously said, 'I can explain it to you, but I can't understand it for you.'
When I asked the Maryland Department of Energy (Director Woolf) this question I was transferred four times to a different phone line, and after that I received no answer.
My goodness. OVERREACTION. Even if you assume that the state department of energy knew why a single gas station raised it prices, and even if you further assume that they could do something about it, a gas price increase of 2.5% justify a call to a government agency when gas prices have famously been up and down to the order of 100% in 1 year? (Answer: no.)
It seems that nobody can explain to me why the gas is going up again in the past few weeks. All I wanted was a simple explanation. I tried asking the gas station owner, and everyone gives you a different answer.
KATHY, Annapolis
For everything you might want to know about gas prices, click HERE. But, Kathy, you asked for a simple explanation, so I'm going to give it to you. There are only 2 possible reasons why the price of gas might have changed:
1. supply
2. demand
Retail gas stations are one of the most awesome studies in capitalism one could want. There are basically an unlimited amount of places that could sell you gas, all of those places sell the same thing, and the price of that thing is posted on a huge sign. The risk of collusion amongst gas station owners, as well as the risk of arbitrary or predatory pricing, is low. If one gas station raises the price, you can go to another station, and the original gas station will not make any money.
So, why specifically may the price have gone up? Here are some possible reasons:
-increased demand for Memorial Day Weekend
-increased demand due to summer/vacation traveling
-increase in the price gas stations have to pay to get the gasoline
I suspect if you look at recent economic news you will find evidence suggesting some combination of those things is at work.
And on to the next letter.
On the night of May 29, I was astonished to see the platoon of local police and state troopers loitering the Dock Street area.
Do platoons exist in police forces? Also, it is not so astonishing to see police officers on patrol near a crowded area.
The officers, who were decked out in their tactical body armor as if an invasion was imminent,..
an imminent invasion?
..blatantly parked their cruisers in the middle of the street. While the officers focused their attention to the pretty women waiting to get inside the bar, vehicular traffic was forced to zig-zag around their cruisers.
I get the feeling that this guy really doesn't like the police. So far he has characterized them as being in a military unit and wearing body armor, all the while chatting up bar-going ladies. I often wear body armor when talking to women, for reasons I wish not to reveal.
The scene immediately reminded me of the Gestapo during World War II or the Berlin border of 1985.
Ah yes, I remember that the main complaint against the Gestapo was their disruption of traffic patterns.
At what point did the city of Annapolis sacrifice freedom for security? I completely understand the importance of projecting an image of security for the people of Annapolis. This method projected fear, not security.
ANTONIO, Annapolis
Allright. First of all, it sounds like they were actually providing security, rather than "projecting an image of security". If people were waiting in line to get into a bar, as you mention, that means the time of day was nighttime. Having police near the bars at nighttime seems like a very reasonable police practice.
And on to what I really wanted to talk about: freedom vs. security. I believe that security always comes before freedom, provided the decrease in freedom really does provide an increase in security. 'Life, liberty, and the pursuit of happiness' are famously listed as unalienable rights, but life comes before liberty both in the wording of the Declaration, and logically.
Now, this doesn't mean that our rights can be infringed upon cart blanche based on a vague correlation to a public safety danger. I have devised some examples:
-having money involuntarily taken from you (taxes) and used to fund a national military: acceptable.
-being confined to your home by the government to prevent possible spread of cold virus: unacceptable.
-having to zig-zag around police cars so officers can address possible problems with late night bar patrons: acceptable.
-being involuntarily drafted into military service: ehh, ??
-allowing warrantless wire taps to prevent terrorist attacks: ehh, ??
There is much room for debate. However, if the abridgement of rights is justified by an increase in safety, then we should be ready to sacrifice some freedom.
1. I can engage in a debate without giving the person I am debating a chance to respond, which makes it much less stressful for me.
2. Letter writers feel compelled to write about a variety of issues, which gives me the chance to comment on many issues that would otherwise be irrelevant.
Today, we have 2 letters. Let's begin!
I noticed gasoline prices are slowly climbing up again, a few cents more every few days.
I recently noticed Mrs. Politics was slowly taking more and more pennies out of my piggy bank, but you don't see me complaining.
On Sunday night the gasoline was $2.39 and on Monday morning the same gas station had changed it to $2.45. I cannot understand why gasoline would go up from a Sunday night to a Monday morning by 6 cents.
I have a bad feeling about where this letter is going. As one former Ward 1 Alderman infamously said, 'I can explain it to you, but I can't understand it for you.'
When I asked the Maryland Department of Energy (Director Woolf) this question I was transferred four times to a different phone line, and after that I received no answer.
My goodness. OVERREACTION. Even if you assume that the state department of energy knew why a single gas station raised it prices, and even if you further assume that they could do something about it, a gas price increase of 2.5% justify a call to a government agency when gas prices have famously been up and down to the order of 100% in 1 year? (Answer: no.)
It seems that nobody can explain to me why the gas is going up again in the past few weeks. All I wanted was a simple explanation. I tried asking the gas station owner, and everyone gives you a different answer.
KATHY, Annapolis
For everything you might want to know about gas prices, click HERE. But, Kathy, you asked for a simple explanation, so I'm going to give it to you. There are only 2 possible reasons why the price of gas might have changed:
1. supply
2. demand
Retail gas stations are one of the most awesome studies in capitalism one could want. There are basically an unlimited amount of places that could sell you gas, all of those places sell the same thing, and the price of that thing is posted on a huge sign. The risk of collusion amongst gas station owners, as well as the risk of arbitrary or predatory pricing, is low. If one gas station raises the price, you can go to another station, and the original gas station will not make any money.
So, why specifically may the price have gone up? Here are some possible reasons:
-increased demand for Memorial Day Weekend
-increased demand due to summer/vacation traveling
-increase in the price gas stations have to pay to get the gasoline
I suspect if you look at recent economic news you will find evidence suggesting some combination of those things is at work.
And on to the next letter.
On the night of May 29, I was astonished to see the platoon of local police and state troopers loitering the Dock Street area.
Do platoons exist in police forces? Also, it is not so astonishing to see police officers on patrol near a crowded area.
The officers, who were decked out in their tactical body armor as if an invasion was imminent,..
an imminent invasion?
..blatantly parked their cruisers in the middle of the street. While the officers focused their attention to the pretty women waiting to get inside the bar, vehicular traffic was forced to zig-zag around their cruisers.
I get the feeling that this guy really doesn't like the police. So far he has characterized them as being in a military unit and wearing body armor, all the while chatting up bar-going ladies. I often wear body armor when talking to women, for reasons I wish not to reveal.
The scene immediately reminded me of the Gestapo during World War II or the Berlin border of 1985.
Ah yes, I remember that the main complaint against the Gestapo was their disruption of traffic patterns.
At what point did the city of Annapolis sacrifice freedom for security? I completely understand the importance of projecting an image of security for the people of Annapolis. This method projected fear, not security.
ANTONIO, Annapolis
Allright. First of all, it sounds like they were actually providing security, rather than "projecting an image of security". If people were waiting in line to get into a bar, as you mention, that means the time of day was nighttime. Having police near the bars at nighttime seems like a very reasonable police practice.
And on to what I really wanted to talk about: freedom vs. security. I believe that security always comes before freedom, provided the decrease in freedom really does provide an increase in security. 'Life, liberty, and the pursuit of happiness' are famously listed as unalienable rights, but life comes before liberty both in the wording of the Declaration, and logically.
Now, this doesn't mean that our rights can be infringed upon cart blanche based on a vague correlation to a public safety danger. I have devised some examples:
-having money involuntarily taken from you (taxes) and used to fund a national military: acceptable.
-being confined to your home by the government to prevent possible spread of cold virus: unacceptable.
-having to zig-zag around police cars so officers can address possible problems with late night bar patrons: acceptable.
-being involuntarily drafted into military service: ehh, ??
-allowing warrantless wire taps to prevent terrorist attacks: ehh, ??
There is much room for debate. However, if the abridgement of rights is justified by an increase in safety, then we should be ready to sacrifice some freedom.
Saturday, November 8, 2008
Financial Crisis: The Government Failed In Many Places
I've decided that it doesn't make much sense to attempt an all-encompassing post on the current economic conditions--partly because it would take too much time and effort, and mostly because it would clearly be presumptuous of me to claim to be able to explain it all. But, there are things that people are failing to understand. This is from a Capital (online) letter writer:
The stance of many, notably the Obama campaign, is that the blame for our financial crisis lies mainly in the failure of government regulators. I tend to believe that the regulators knew what was going on, but were powerless to do anything because their interests were in conflict with a more momentous political prerogative. Let's discuss!
Leverage is a great way to make money, and a great way to lose it really quick. It's important to understand that leverage is tied to the assets being leveraged (borrowed against). In this case, artificially easy credit and artificially high demand for homes eventually dried up, rendering the writer's leverage complaint valid.
For most people, their homes are their chief investment. Taking that a step further, securities that are tied to mortgages make up a huge pool of investments, and a huge pool of profit for the companies mentioned in the above letter. The government, via Fannie and Freddy, distorted the market for mortgage-backed securities, and essentially forced such risky behavior. Acting on the assumption that every family deserves to own a home--a notion that is much younger than some might think--Fannie and Freddy created demand for sub prime loans by buying them from mortgage lenders. Banks felt the need to participate, lest they lose ground to the competition. Bottom line: the fault does not lie with unregulated capitalism, it lies with the government's forced limitation of free-market principles.
Perhaps more alarming is the preferred method of bailing these companies out. In the late 1990's, a hedge fund named Long Term Capital Management was on the brink of bankruptcy. To put it in perspective, they were leveraged at least 30:1, and probably more--they were very secretive and nobody really knew where their money was or how much was at risk. A failure of LTCM was thought to have far-reaching effects, as many banks had significant stakes. After a bailout offer from Warren Buffet was rejected, the Fed was brought in. BUT, rather than bail the fund out themselves, the Fed merely acted as a mediator--orchestrating a $525 billion bailout from the fund's creditors, and not the taxpayers.
The contemporary method to bail out companies is direct investment or securitization from the government. Unlike the creditors or investors of a company, the government has significantly less expertise in monitoring the company, and significantly less incentive to recover its money (because the government doesn't have its own money, it has our money). And whereas investors only deal with their investments, the government has no clearly defined restraints. First it was only banks that got special protection. Then investment banks. Then an insurance company. Now maybe the auto industry. The list will stop when the government stops sending good money to chase after bad.
Many firms on Wall Street and around the world ran up debt-to-equity ratios
larger than 30 to 1. That means they borrowed $30 for every $1 they actually
had. They didn't get to that point on the strength of mortgages to poor people.
They were playing a leverage casino far beyond the subprime market.
When Lehman Brothers collapsed, its ratio was 45 to 1. That is what is
causing Wall Street to collapse in less than a month, at our great expense. Our
government, including both political parties, have failed us by ignoring the
abuses and failing to exercise proper oversight of the financial industry. Let's
give credit where credit is due.
The stance of many, notably the Obama campaign, is that the blame for our financial crisis lies mainly in the failure of government regulators. I tend to believe that the regulators knew what was going on, but were powerless to do anything because their interests were in conflict with a more momentous political prerogative. Let's discuss!
Leverage is a great way to make money, and a great way to lose it really quick. It's important to understand that leverage is tied to the assets being leveraged (borrowed against). In this case, artificially easy credit and artificially high demand for homes eventually dried up, rendering the writer's leverage complaint valid.
For most people, their homes are their chief investment. Taking that a step further, securities that are tied to mortgages make up a huge pool of investments, and a huge pool of profit for the companies mentioned in the above letter. The government, via Fannie and Freddy, distorted the market for mortgage-backed securities, and essentially forced such risky behavior. Acting on the assumption that every family deserves to own a home--a notion that is much younger than some might think--Fannie and Freddy created demand for sub prime loans by buying them from mortgage lenders. Banks felt the need to participate, lest they lose ground to the competition. Bottom line: the fault does not lie with unregulated capitalism, it lies with the government's forced limitation of free-market principles.
Perhaps more alarming is the preferred method of bailing these companies out. In the late 1990's, a hedge fund named Long Term Capital Management was on the brink of bankruptcy. To put it in perspective, they were leveraged at least 30:1, and probably more--they were very secretive and nobody really knew where their money was or how much was at risk. A failure of LTCM was thought to have far-reaching effects, as many banks had significant stakes. After a bailout offer from Warren Buffet was rejected, the Fed was brought in. BUT, rather than bail the fund out themselves, the Fed merely acted as a mediator--orchestrating a $525 billion bailout from the fund's creditors, and not the taxpayers.
The contemporary method to bail out companies is direct investment or securitization from the government. Unlike the creditors or investors of a company, the government has significantly less expertise in monitoring the company, and significantly less incentive to recover its money (because the government doesn't have its own money, it has our money). And whereas investors only deal with their investments, the government has no clearly defined restraints. First it was only banks that got special protection. Then investment banks. Then an insurance company. Now maybe the auto industry. The list will stop when the government stops sending good money to chase after bad.
Tuesday, September 16, 2008
"Too Important To Fail" Is The New Argument For Socialism
Using strict statistical methods, I have calculated that my productivity has dropped by a record 8% in the last 48 hours while I try and sort through the financial nightmare that is terrorizing some major money moguls as we speak. The latest victim is AIG, which just ceded an 80% stake to The Federal Reserve (yikes) for a barely fathomable $85 billion.
Historically, the government has identified industries that are too big or too important to fail. Amtrak and the airlines both have enjoyed government favoritism to some extent. But the financial industry is in a class by itself. The Federal Reserve came in 1913, and the FDIC came in 1933, creating a foundation for a system that now allows firms to make stupid decisions and people to obtain stupid loans.
In case you didn't realize this by now, with public goods being the notable exception, when the government gets involved in industry it screws everything up, and necessarily produces a result inferior to that of the private market. What incentive do banks have to make responsible loans if the government is going to bail them out?
As an economics student, I learned the virtues of the Fed. After all, countries need central banks. But, the Fed's purposes have evolved. Originally meant to control bank panics, it became a regulatory agency for banks, a monetary policy instrument, and a lender of last resort to banks. There has been some history of the Fed serving as a mediator and broker for emergency rescues of too-big-to-fail financial institutions, with Long Term Capital Management being perhaps the most noteworthy. But in the last 6 months, the Fed has pushed even that boundary and has acted a lender of last resort to investment banks (not regular banks), and now, today, has apparently nationalized the nation's largest insurer! Not only are we taxpayers on the hook for the first $85 billion, but I'm quite sure AIG is about to shell out infinity billion dollars to rebuild Texas from Hurricane Ike--are we going to have to pay for that too?!!!!
If that weren't scary enough, consider this: at some point, the Democrat Congress is going to realize that they now have an 80% stake in an insurance company. Democrats want national health insurance. Get the picture?
I hope to research a mega-post on this, but in case I don't, here's what I'm thinking. Most of this is the fault of Democrats, not of the free market or capitalism. Democrats created Fannie Mae and Freddy Mac, and Democrats ran those agencies into the ground while cooking the books and pocketing tens of millions of dollars. When President Bush tried to reform those agencies in 2003 (I think), Democrats blocked it. Fannie and Freddie gave millions of lobbying dollars to Democrats (Obama, Hillary, and Biden were all in the top 5 I think...McCain was #342)--which essentially means the government was lobbying the Democrat part of itself--and we can now see why.
Even so, I am not happy with the Bush administration. That itwould allow such an overt breach of free-market principles is horrible. If the Fed did this unilaterally using its independence, then we need to find limits to the Fed's powers outside of monetary policy. To borrow terminology from Warren Buffet, we the taxpayers are throwing good money after bad money, and we didn't have an ounce of say about it. Earlier in the post I announced that the latest victim was AIG, but the true victim is us.
Historically, the government has identified industries that are too big or too important to fail. Amtrak and the airlines both have enjoyed government favoritism to some extent. But the financial industry is in a class by itself. The Federal Reserve came in 1913, and the FDIC came in 1933, creating a foundation for a system that now allows firms to make stupid decisions and people to obtain stupid loans.
In case you didn't realize this by now, with public goods being the notable exception, when the government gets involved in industry it screws everything up, and necessarily produces a result inferior to that of the private market. What incentive do banks have to make responsible loans if the government is going to bail them out?
As an economics student, I learned the virtues of the Fed. After all, countries need central banks. But, the Fed's purposes have evolved. Originally meant to control bank panics, it became a regulatory agency for banks, a monetary policy instrument, and a lender of last resort to banks. There has been some history of the Fed serving as a mediator and broker for emergency rescues of too-big-to-fail financial institutions, with Long Term Capital Management being perhaps the most noteworthy. But in the last 6 months, the Fed has pushed even that boundary and has acted a lender of last resort to investment banks (not regular banks), and now, today, has apparently nationalized the nation's largest insurer! Not only are we taxpayers on the hook for the first $85 billion, but I'm quite sure AIG is about to shell out infinity billion dollars to rebuild Texas from Hurricane Ike--are we going to have to pay for that too?!!!!
If that weren't scary enough, consider this: at some point, the Democrat Congress is going to realize that they now have an 80% stake in an insurance company. Democrats want national health insurance. Get the picture?
I hope to research a mega-post on this, but in case I don't, here's what I'm thinking. Most of this is the fault of Democrats, not of the free market or capitalism. Democrats created Fannie Mae and Freddy Mac, and Democrats ran those agencies into the ground while cooking the books and pocketing tens of millions of dollars. When President Bush tried to reform those agencies in 2003 (I think), Democrats blocked it. Fannie and Freddie gave millions of lobbying dollars to Democrats (Obama, Hillary, and Biden were all in the top 5 I think...McCain was #342)--which essentially means the government was lobbying the Democrat part of itself--and we can now see why.
Even so, I am not happy with the Bush administration. That itwould allow such an overt breach of free-market principles is horrible. If the Fed did this unilaterally using its independence, then we need to find limits to the Fed's powers outside of monetary policy. To borrow terminology from Warren Buffet, we the taxpayers are throwing good money after bad money, and we didn't have an ounce of say about it. Earlier in the post I announced that the latest victim was AIG, but the true victim is us.
Friday, July 4, 2008
The Economics of Oil
My normal method of blogging involves typing a secret password into the Republican National Committee Mainframe, and plagiarizing whatever bit of propaganda that has already been developed for my particular issue. For this post, I decided to research facts on my own, which took like 3 weeks of hard work, confirming my worst suspicions. So, I hope you take the time to read this post, because I took the time to write it!
With consumers facing record prices at the pump, there is plenty of anger to be directed and misdirected at various sources. After doing some research, I am now marginally more prepared than I otherwise would have been to present you with the facts about the oil business, and which factors weigh the most on the price of gas and heating oil.
Crude oil is pumped out of the ground, then shipped via tanker or pipeline. The world's largest consumers (North America, Europe, Asia) all import oil, and all other regions export it. The general rule is that it is cheapest to refine oil when it is close to its final source; therefore, oil is almost always shipped in the crudest form possible, and the biggest consumers are also the biggest refiners.
The only US port that can accommodate oil supertankers is in Louisiana, so often the supertankers divide their cargo onto smaller tankers that can go directly into any port, where it then goes to refineries. The Gulf region, specifically Texas and Louisiana, refine more oil than anywhere else in the country. No new refineries have been built since 1976, but refineries have seen significant technological advances. Most demand for refined oil is in the form of light products such as gasoline (think "light sweet crude"). Refineries in the US have focused on something called "downstream processing", which allows refineries to take crude oil and produce up to 60% gasoline, as opposed to the 20% produced by more rudimentary refineries. Many refineries without downstream capabilities were shut down, and the utilization of the remaining refineries remained high.
We use oil for a lot of things: gasoline, propane, food wax, motor oil, asphalt, petrochemicals, and more. Downstream refining allows refineries to quickly adapt to the particular demand profile of final products, and those products are sold to retailers.
The gasoline marketers are a particularly interesting case. Most gas stations that we are familiar with are supermajor brands, whereas a 'supermajor' or 'major' is an oil company that has reserves, refineries, and retail stations. There are 6 supermajors: Exxon, Shell, BP, Chevron, ConocoPhillips, and Total S.A. But all is not as it seems....over 95% of retail stations are independently owned--not owned by the supermajors. The retail stations may or may not be part of a regional distributor, but what they do have is a branding agreement with their respective supermajor to sell only that company's gas.
This brings us to the next item: how gas stations get their gas. When refined gasoline comes to port, it is up for sale. Distributors and branded stations may have some power to set prices--but not much. They have to buy gas from their supermajor's refinery, and cannot shop for the best price. Conversely, the generic gas stations are free to shop the best price, and can typically have some effect on the price they pay, resulting in lower prices at the pump. Consumers decide if they want the lowest price, or the consistency of a proprietary gas blend.
Supply
OPEC countries control about 40% of the world's oil production, with everyone else accounting for the rest. Mining oil supply consists of several steps, including finding the oil, drilling a test well to see if the total find is economically viable, then setting up a pumping operation.
As noted above, most of the world's oil supply is located in the Middle East.
Oil supply has typically fallen victim to a low success rate. Exploration of fields where oil has not already been found historically yields only a 20% chance for finding a supply that is economically viable to pump. Much like in refining, technology improvements have increased this success rate to as high as 50%--still a risky proposition considering the costs involved with finding oil.
The most important feature of the supply for oil is that it is not perfectly competitive. Markets work best when they are perfectly competitive: involving numerous or infinite participants, no restrictions on trade, and no barriers to entry. The supply market for oil has none of those features; rather, it is characterized by high fixed costs and relatively few participants (companies).
Let's consider why. If you want to start a handyman business, all you have to do is buy a hammer and convince your mother that your father hung a painting crooked, and you have your first job. If you want to start a company to pump oil, you need infinity government permits and like a hundred billion dollars.
A market in which suppliers are relatively few, and each relatively large, is called an oligopoly, and the oil market is indeed oligopolistic. And the think about oligopolies is, they usually band together to form a cartel. OPEC is the biggest cartel the world has ever known, and they can basically exert their will over the supply market. In a competitive market, individual suppliers have no control over the price they can charge. If you charge $30 per hour to be a handyman, and there are 10 other guys on your street who do the same job as you for $25 an hour, you will be out of work--you have no choice but to charge the market rate. But for OPEC, they control such a large share of the supply that they can control the price through their decision of how much oil to bring to market. Since there are not enough other suppliers with excess capacity to steal business from OPEC, refiners must buy OPEC oil and bid the price up or down based on scarcity.
It is important to note the price elasticity of oil supply, which means how sensitive oil supply is to price. The more sensitive supply is to price, the more elastic supply is said to be. The more the price of a good goes up, the more of that good suppliers want to produce, as would be expected. If everyone in the country wanted handyman services and the going rate for handymen jumped to $500 an hour, you would cancel your engagements, dump your girlfriend, and try and perform your handyman duties all day long--the supply for handyman services is relatively elastic.
Oil suppliers, on the other hand, cannot respond so quickly. Just because the price of a barrel of crude goes from $100 to $130 overnight doesn't necessarily mean that oil suppliers can capitalize on the higher price by producing more. This is because oil exploration is a lengthy process, and because there are no close substitutes to oil production--oil producers cannot change their oil rigs to produce natural gas if the price of oil drops and gas rises. An elasticity of 0 means total dependence on price, and an elasticity of 1 means total independence of price--oil supply elasticity has been estimated at .1, which is relatively inelastic.
So, how much supply do we still have? Well, nobody really knows because there is still oil that we don't know about plus OPEC countries are shady with their reports of how much they already have. As recently as 2 days ago, The Economist reports that the world has enough oil to accommodate current consumption levels for 42 years. Of note, it also states this is slightly more than last year, implying that we are currently discovering oil slightly faster than we are using it.
The USA has proven reserves to supply ourselves with oil for 3 years given our current usage and without dependence on foreign oil.
Oil supply is a shaky thing. There is always a risk of a supply shock, which refers to an immediate and significant drop in production. I must say that there are reasons to be pessimistic about future supply. First and foremost, oil is not a renewable resource and will eventually run out if we keep using it. Short-term supply is maxed out. Some people think that Saudi Arabia could pump a couple more million barrels a day but that's about it. Long-term supply doesn't look much better. Politicians in the United States are gallivanting around failing to pump or build refineries. Politicians in China need all the oil they make (for the first time), and Russia's oil industry is suffering at a time when demand is peaking.
Demand
First things first: consumption = demand. Now then, industrialized countries consume much more oil than less industrialized companies, and the US and Canada consume the most. Canada and the US consume 3 gallons of oil per person per day, whereas the rest of the developed world averages about 1.4, the undeveloped world .2. The difference is attributed to transportation sectors, where in the US and Canada private vehicles are heavily utilized to travel relatively long distances.
(Column Intermission: If any of you are still reading this, I'm quite sure you are tired of words. I just found a great power point presentation that has a lot of this info in short blurbs, with pretty colors. So look at it if you want!)
The United States is the biggest consumer of oil in the world, using nearly 3 times as much total oil as the next largest user (China). The US consumes between 20 and 21 million barrels per day of oil, which is actually at or below what is has been this decade.
Based on the above graph, the free market price would be 600 and the quantity produced would be 5 (I am just reading the numbers on the axes for simplicity). But in this market, the government has mandated a price of 400! So, the quantity demanded equals 7, but the quantity supplied eqauls 3--creating an oil shortage of 4. Price ceilings create supply shortages. China is the example that we can point to in the oil market.
With consumers facing record prices at the pump, there is plenty of anger to be directed and misdirected at various sources. After doing some research, I am now marginally more prepared than I otherwise would have been to present you with the facts about the oil business, and which factors weigh the most on the price of gas and heating oil.
Ownership Of Oil Reserves
You all know the equation: big oil = Exxon Mobil = Beelzebub. But in the scheme of things, Exxon is small oil. The truly big oil are the nationally owned companies of many oil rich nations. (Note to readers: state ownership = communism). In fact, state-owned oil companies control 90% of the world's oil. Here is the list of the 20 largest oil companies by reserves (not production):
1. Saudi Arabian Oil Company**
2. National Iranian Oil Company**
3. Qatar Petroleum**
4. Abu Dabhi National Oil Company** (United Arab Emirates)
5. Iraq National Oil Company**
6. Gazprom (Russia)
7. Kuwait Petroleum Company**
8. PDVSA** (Venezuela)
9. Nigerian National Petroleum Corporation**
10. National Oil Corporation** (Libya)
11. Sonatrach** (Algeria)
12. Rosneft (Russia)
13. Petronas (Malaysia)
14. Exxon Mobil* (USA)
15. Lukoil* (Russia)
16. Pemex (Mexico)
17. Petrochina* (China)
18. BP* (England)
19. Chevron* (USA)
20. Petrobras (Brazil)
(*Public, ** OPEC)
The Supply ChainCrude oil is pumped out of the ground, then shipped via tanker or pipeline. The world's largest consumers (North America, Europe, Asia) all import oil, and all other regions export it. The general rule is that it is cheapest to refine oil when it is close to its final source; therefore, oil is almost always shipped in the crudest form possible, and the biggest consumers are also the biggest refiners.
The only US port that can accommodate oil supertankers is in Louisiana, so often the supertankers divide their cargo onto smaller tankers that can go directly into any port, where it then goes to refineries. The Gulf region, specifically Texas and Louisiana, refine more oil than anywhere else in the country. No new refineries have been built since 1976, but refineries have seen significant technological advances. Most demand for refined oil is in the form of light products such as gasoline (think "light sweet crude"). Refineries in the US have focused on something called "downstream processing", which allows refineries to take crude oil and produce up to 60% gasoline, as opposed to the 20% produced by more rudimentary refineries. Many refineries without downstream capabilities were shut down, and the utilization of the remaining refineries remained high.
We use oil for a lot of things: gasoline, propane, food wax, motor oil, asphalt, petrochemicals, and more. Downstream refining allows refineries to quickly adapt to the particular demand profile of final products, and those products are sold to retailers.
The gasoline marketers are a particularly interesting case. Most gas stations that we are familiar with are supermajor brands, whereas a 'supermajor' or 'major' is an oil company that has reserves, refineries, and retail stations. There are 6 supermajors: Exxon, Shell, BP, Chevron, ConocoPhillips, and Total S.A. But all is not as it seems....over 95% of retail stations are independently owned--not owned by the supermajors. The retail stations may or may not be part of a regional distributor, but what they do have is a branding agreement with their respective supermajor to sell only that company's gas.
This brings us to the next item: how gas stations get their gas. When refined gasoline comes to port, it is up for sale. Distributors and branded stations may have some power to set prices--but not much. They have to buy gas from their supermajor's refinery, and cannot shop for the best price. Conversely, the generic gas stations are free to shop the best price, and can typically have some effect on the price they pay, resulting in lower prices at the pump. Consumers decide if they want the lowest price, or the consistency of a proprietary gas blend.
Supply
OPEC countries control about 40% of the world's oil production, with everyone else accounting for the rest. Mining oil supply consists of several steps, including finding the oil, drilling a test well to see if the total find is economically viable, then setting up a pumping operation.
As noted above, most of the world's oil supply is located in the Middle East.
Oil supply has typically fallen victim to a low success rate. Exploration of fields where oil has not already been found historically yields only a 20% chance for finding a supply that is economically viable to pump. Much like in refining, technology improvements have increased this success rate to as high as 50%--still a risky proposition considering the costs involved with finding oil.
The most important feature of the supply for oil is that it is not perfectly competitive. Markets work best when they are perfectly competitive: involving numerous or infinite participants, no restrictions on trade, and no barriers to entry. The supply market for oil has none of those features; rather, it is characterized by high fixed costs and relatively few participants (companies).
Let's consider why. If you want to start a handyman business, all you have to do is buy a hammer and convince your mother that your father hung a painting crooked, and you have your first job. If you want to start a company to pump oil, you need infinity government permits and like a hundred billion dollars.
A market in which suppliers are relatively few, and each relatively large, is called an oligopoly, and the oil market is indeed oligopolistic. And the think about oligopolies is, they usually band together to form a cartel. OPEC is the biggest cartel the world has ever known, and they can basically exert their will over the supply market. In a competitive market, individual suppliers have no control over the price they can charge. If you charge $30 per hour to be a handyman, and there are 10 other guys on your street who do the same job as you for $25 an hour, you will be out of work--you have no choice but to charge the market rate. But for OPEC, they control such a large share of the supply that they can control the price through their decision of how much oil to bring to market. Since there are not enough other suppliers with excess capacity to steal business from OPEC, refiners must buy OPEC oil and bid the price up or down based on scarcity.
It is important to note the price elasticity of oil supply, which means how sensitive oil supply is to price. The more sensitive supply is to price, the more elastic supply is said to be. The more the price of a good goes up, the more of that good suppliers want to produce, as would be expected. If everyone in the country wanted handyman services and the going rate for handymen jumped to $500 an hour, you would cancel your engagements, dump your girlfriend, and try and perform your handyman duties all day long--the supply for handyman services is relatively elastic.
Oil suppliers, on the other hand, cannot respond so quickly. Just because the price of a barrel of crude goes from $100 to $130 overnight doesn't necessarily mean that oil suppliers can capitalize on the higher price by producing more. This is because oil exploration is a lengthy process, and because there are no close substitutes to oil production--oil producers cannot change their oil rigs to produce natural gas if the price of oil drops and gas rises. An elasticity of 0 means total dependence on price, and an elasticity of 1 means total independence of price--oil supply elasticity has been estimated at .1, which is relatively inelastic.
So, how much supply do we still have? Well, nobody really knows because there is still oil that we don't know about plus OPEC countries are shady with their reports of how much they already have. As recently as 2 days ago, The Economist reports that the world has enough oil to accommodate current consumption levels for 42 years. Of note, it also states this is slightly more than last year, implying that we are currently discovering oil slightly faster than we are using it.
The USA has proven reserves to supply ourselves with oil for 3 years given our current usage and without dependence on foreign oil.
Oil supply is a shaky thing. There is always a risk of a supply shock, which refers to an immediate and significant drop in production. I must say that there are reasons to be pessimistic about future supply. First and foremost, oil is not a renewable resource and will eventually run out if we keep using it. Short-term supply is maxed out. Some people think that Saudi Arabia could pump a couple more million barrels a day but that's about it. Long-term supply doesn't look much better. Politicians in the United States are gallivanting around failing to pump or build refineries. Politicians in China need all the oil they make (for the first time), and Russia's oil industry is suffering at a time when demand is peaking.
Demand
First things first: consumption = demand. Now then, industrialized countries consume much more oil than less industrialized companies, and the US and Canada consume the most. Canada and the US consume 3 gallons of oil per person per day, whereas the rest of the developed world averages about 1.4, the undeveloped world .2. The difference is attributed to transportation sectors, where in the US and Canada private vehicles are heavily utilized to travel relatively long distances.
Gasoline is by far the most important refined oil product, accounting for 45% of total oil consumption. But there are certainly other products, and other uses besides oil for transportation.
The most important demand issue is probably the trends in world demand. The developed countries are feeling the sting of higher prices, and demand for oil in the OECD countries is predicted to decline by 240,000 barrels in 2008. Developing countries, however, are still seeing growth in oil demand. China and its 400 ka-billion people have seen average annual growth in oil demand of 9% since 1990, and predictions are for another 5.5% increase this year! China is consuming about 7.4 million barrels per day of oil.
Now back to Russia...despite the misfortune of its oil producing industries, many of its other industries are starting to hit their stride. Russian oil demand in the 1990's fell off as the economy struggled to reorganize after the fall of communism. As luck would have it, one of the industries to recover in this decade is the auto industry, and as we know, autos need gas. Russian automobile sales have tripled in the past 5 years, and forecasts predict that Russia will account for more auto sales than any other European country by 2010.(Column Intermission: If any of you are still reading this, I'm quite sure you are tired of words. I just found a great power point presentation that has a lot of this info in short blurbs, with pretty colors. So look at it if you want!)
The United States is the biggest consumer of oil in the world, using nearly 3 times as much total oil as the next largest user (China). The US consumes between 20 and 21 million barrels per day of oil, which is actually at or below what is has been this decade.
For economists and other general nerds, the price elasticity of demand is a fascinating study. By how much do gas prices have to increase for people to car pool? By how much do they have to rise before people cancel their vacations? Before they move closer to work? Once the current oil volatility settles, maybe in a couple of years, we will have a fabulously accurate answer to that question. As for now, I found an oil demand elasticity estimate of .1, meaning that gas prices would have to rise by 10% to induce a 1% reduction in usage. Compared to other goods this is particularly extreme; in other words, we are more addicted to oil than most other goods.
How the Market Works
Markets determine how much of a good is sold, and at what price, by the intersection of supply and demand. Supply curves are upward sloping, meaning that as a price of a good rises, producers of the good want to sell more of it. Demand curves are downward sloping, meaning that as the price of a good increases, people want less of it.
The demand side is easy. Individual people have no affect on the price of oil; they simply decide how much oil they want to use given the market price. The supply side is where all the magic happens. Oil companies have to find the oil, which is a pain in the ass. They pump the easiest stuff first, then move on. It is critical to understand this investment decision. If all of the Great Lakes were made of oil instead of water, oil companies would be willing to sell gas really cheap because all they would need is a bucket to scoop it out--their fixed cost would be relatively low.
Sadly, the Great Lakes oil would be quickly used because it would be so cheap. The oil companies would then have to pump oil from deeper into the ground. They would need seismographs to find the oil, drills to access the oil, and numerous environmental permits. Their fixed cost would increase dramatically, and this cost would be incorporated into a gallon of gas. As oil becomes more scarce, it becomes more expensive to pump out of the ground, causing the supply curve to shift upward and raising the general price of oil.
Oil exploration does not continue forever. Oil companies know how much it costs to search for the next oil site, and will not undertake drilling or exploration if the market price of oil will not produce a positive return on investment. That point is is the single most important policy implication of oil economics. If the price of oil is high, more exploration investments will be profitable, leading to increased oil supply, and reduced oil prices. Consider this excerpt from The Economist:
No one in the Saudi oil ministry has forgotten what happened after the oil shock
in the 1970s. The Arab boycott called in 1973 to protest against Western backing
for Israel tripled oil prices. But it also prompted oil exploration in tricky
places such as the North Sea and conservation measures that reduced demand. The
result was a long-term slump in crude prices and a drop in the Saudis' market
share.
Markets work, and this is a beautiful thing. The simple supply and demand interaction outlines by Adam Smith in 1776 can predict almost any outcome--maybe not perfectly, but darn close. Free markets create incentives, and incentives drive behavior. If oil costs too much, oil companies will explore more, and the price will go down. Then, people will demand less of the oil at the new higher price, and the price will go down. So prices go down! Suppliers then cut back while people consume more, and the process reverses itself. The market always gravitates towards its equilibrium.
Market Failure: The Government
The 'how the market works section' above is one of the shortest sections of this post, because markets are pretty simple.....except when the government screws them up. The first government market distortion is environmental permits. For places where drilling is allowed, this is relatively small potatoes--maybe several months of waiting and a couple hundred thousand dollars; I really have no idea, but my guess is that it doesn't distort the investment decision. But consider the extreme, where exploration is prohibited by the government for environmental or other reasons (think ANWAR). In this case, the oil companies cannot move along their natural progression of supply sources, causing a dramatic upward shift in the supply curve and artificially high prices.
Government market distortion #2: TAXES! The tax concept is easy to illustrate using a business decision that most of us have to make at some point: buying a house. A common bit of information listed for potential buyers is the total annual taxes. Let's say a million dollar house in Annapolis incurs a $15,000 per year tax bill. Fine. If a million dollar house in a less desirable area cost only $14,999 in taxes each year, would you buy that house? Of course not. But what if the less desirable house had a tax bill of only $1000 per year? That's a big difference--maybe enough to change your investment decision. As noted above, the oil companies calculate the profit they expect to make from pumping through comparison of the cost of that pumping operation and the market price of refined oil. Taxes simply add to the cost of production. The higher that taxes are, the lower the return on investment, the less oil that is explored, the lower the supply, the higher the price.
Government market distortion #3: price ceilings. Taxes, at least, are a traditional and therefore relatively predictable circumstance. When the government regulates such a specific condition as how much a business can charge for its goods and services, that market will inevitably have a mismatched supply and demand. Supply curves are upward sloping and demand curves are downward sloping; the market price and quantity produced are determined by their intersection: 
Now lets take a look at what happens in the case of price ceilings:
Based on the above graph, the free market price would be 600 and the quantity produced would be 5 (I am just reading the numbers on the axes for simplicity). But in this market, the government has mandated a price of 400! So, the quantity demanded equals 7, but the quantity supplied eqauls 3--creating an oil shortage of 4. Price ceilings create supply shortages. China is the example that we can point to in the oil market.Who Determines Price and The Role of Wall Street Speculators
Supply and demand, even when corrupted by market imperfections, always determine price. If you are ever in a market where the government or some panel of "experts" sets the price, run. Far away. The price of oil is high because world demand is outpacing supply, largely due to political reasons. Demand growth has been unexpected, and there is no excess supply capacity to lower prices in the short run.
Regarding said market (supply) imperfections, we now have to consider them. In a competitive market, producers are numerous and any given producer cannot affect the price of the good being sold. In the oil business, OPEC is a cartel and can control the price of crude by limiting or expanding short-run supply. Note: Exxon, Shell, or any other individual "big oil" company cannot affect the price of oil. They probably couldn't even affect the price if they colluded, and I would hate to see the governmental regulator-types the day after they learned of big-oil collusion. Big oil are price takers, and if you don't believe me you can believe the IMF.
Politics and stupidity also affect the price. Domestically, there has not been a new refinery built in my lifetime, impeding long-term supply growth. OPEC has similarly neglected its infrastructure, causing the same result. We are currently seeing the fruition of this recipe for disaster.
Suppliers as a whole can only move along their supply curve--meaning adjust their level of production based on price--if they have mobility in their production both downwards AND upwards. If total production capacity is at the level of demand, an increase in demand causes a supply shortage and the price starts to move upward. It's been a wee bit since since I stayed current with such things, but I learned the sustainable estimate of industrial capacity to be 82%--meaning that if industrial production is more than 82% of its maximum potential, there tend to be inflationary pressures that push the price of the good upward. Oil production is nearer to 100%, and indeed the price is going up.
There are some who play the blame game with financials, professing the evils to various degrees of either corporate greed and $20 million CEO bonuses, or speculators on Wall Street. The 
Petroleum Marketers Association of America is certainly a loud voice in this room, fulfilling their charge to support gas station owners. The truth is, neither of these 'evils' affects the market fundamentals enough to have even the smallest effect on oil prices. Let's talk speculators first. They deal in future contracts, which essentially means that they bet on the future price of oil deliveries. The first crucial thing to remember is that each future contract has 2 parties: the buyer and the seller. Each party wants to make money, so one side is betting that the price will go up and the other that the price will go down. If they are wrong too often, they will alter the prices they are willing to agree to. The other thing about futures is that they are contracts for actual physical deliveries of oil in the future. But, traders have no interest in receiving the oil, so they sell their futures before they come to maturity. If the supply and demand conditions at that time dictate a different spot price than the price of the future, the trader could make or lose a lot of money--but the price of oil at that time is still dictated by the market fundamentals.
The CEO compensation thing is even more of a joke. Last year, Exxon's CEO got a bounus of $20 million. (Note: Exxon = Exxon Mobil). I am not going to compare that to sales--not even to profit. In the 4th quarter of last year, Exxon spent $6.2 billion on oil exploration. This means that the CEO's bonus was three one-thousandths of 1 percent of the money they spent on oil exploration IN THE FOURTH QUARTER! The scale of Exxon's operations is beyond comprehension, which is why people have trouble accepting the scale of the pay. Let me assure you of 2 things: #1: if their board of directors thought they could hire a CEO that would make them more money for less pay, they would find that person, and #2: giving $20 million to a CEO has absolutely no effect on oil exploration investment decisions, therefore no effect on supply, therefore no effect on the prices you pay at the pump. People got really mad when Exxon gave their old CEO a $400 million retirement package. Consider this: most of that money was in stock, and Exxon's stock valuation is $468 billion. So, in return for making Exxon the largest public company in the world and steering the ship while the stock price went up 500%, the Exxon board gave that guy nine ten-thousandths of 1 percent of outstanding stock. Give me a break. They can do what they want--it's their money and it doesn't affect our money.
Energy Policy and The "Long-Term" Argument
So, what energy policy will lower the price we are paying for gas? This question is undoubetedly why you are still reading this post. Our government cannot control demand to any effecient extent. They cannot control supply that is owned by soverign nations. Individual people can push oil prices down by figuring out ways to consume less, and the government can affect prices by allowing supply capabilities to increase. It's as simple as that.
Imposing a "windfall profits" tax on oil company profits is an example of what the government should NOT do. Whether it's a regular tax, a 'windfall profits' tax, a fee, a cost of getting a license, or any other name for an action when the government takes money from a business--the result is always the same. The supply curve shifts upward because the producer cost structure goes up, and prices are higher for us.
I don't think I will be so presumptuous as to suggest I have a perfect solution. But, I don't think the government does either. In the general sense, I think government should lift restrictions and let the energy companies figure out where drilling, or other energy sources will be viable.The reason why I think this is the proper attitude is that nobody has been able to figure out a good solution yet. Let's talk about the demand side solution. There is little argument, if any, that individuals reducing their own energy consumption cannot be bad. However, any government mandates to control such behavior is an overreach--the benefit does not justify the reduction in liberty.
As for the supply side solution, it's even more confusing. Let's say we mandate battery powered cars--how would we equip the power grid to handle the increase in electricity demand to recharge 100 million batteries every day? Natural gas power plants? Coal? Nuclear? As for ethanol, increased demand has been linked to rising corn prices, and plowing pasture land to plant corn for ethanol releases a negative carbon footprint on the atmosphere!
Some make the argument that energy companies are cannot be trusted to think of long-term solutions because the demands of public stock ownership and of capitalism in general create pressure to make short-term profits. That hazard is certainly possible, but rest assured that businesses would invest in new technologies if they were viable, and the government is not helping that potential return on investment. More importantly, politicians are even less likely to favor long-term solutions because they have to be re-elected every 2, 4, or 6 years!
Petroleoum economics is the same as any other economics--you just have to understand supply and demand. It is fair to say that increasing demand, constrained supply, and fear of supply shock are all pushing up crude prices. Sadly, the oil market is a study in political economy rather than pure economics; 93% of oil reserves are owned by soverign nations. While nations can generally be considered profit maximizers in the oil market, there are politics that undoubtedly determine allocation of the precious resource.
The market will eventually reach the correct prices and resource allocations. If there are high oil profits, companies will undertake more exploration projects, supply will increase, and the oil price will drop. If supply is depleted, companies will work to develop alternatives to meet the energy demand. These companies are expert in such matters, and the government is not. Furthermore, the government cannot do anything to speed a move to market equilibrium: taxes on oil profits discourage exploration, and subsidies for finding more oil delay the development of other technologies. However disappointing or angering some might consider my conclusion, it is the same as it usually is: the government should stay out of the way.
Let me end with the someone else's words, and a rather elegant summation of the future of energy:
The last time such alternatives were widely discussed was during the early
1970s. Then, too, a spike in the price of oil coincided with a fear that natural
limits to supply were close. The newspapers were full of articles on solar
power, fusion and converting the economy to run on fuel cells and hydrogen.Of course, there was no geological shortage of oil, just a politically manipulated one. Nor is there a geological shortage this time round. But that does not matter, for there are two differences between then and now. The first is that this price rise is
driven by demand. More energy is needed all round. That gives alternatives a
real opening.As these alternatives start to roll out in earnest, their rise, optimists hope, will become inexorable. Economies of scale will develop and armies of engineers will tweak them to make them better and cheaper still.
Competition should do the rest—for the fledgling firms of the
alternative-energy industry are in competition with each other as much as they
are with the incumbent fossil-fuel companies. Let a hundred flowers bloom. When
they have, China, too, may find some it likes the look of. Therein lies the best
hope for the energy business, and the planet.
Tuesday, October 2, 2007
Minimum Wage/Living Wage
Two days ago I sat down with the smartest person that I know, and had about a 40 minute conversation about various things. Amongst the things we talked about were the living wage in this state, and minimum wage theory.
I would be fair in saying that my earlier statement condemning the minimum wage was valid, although Dr. Montgomery would maintain that a net benefit of a small minimum wage increase is slightly more likely than what I would claim.
The classic model of economics dictates that as any product or service becomes more expensive, the demand for that product will be decreased. Labor is no different--if wages are higher, there will be less demand for labor, and unemployment will result.
Neo-classic economic arguments focus on the elasticity of labor demand, which means how sensitive labor demand is to price fluctuations.
If demand for labor is completely determined by the price of the labor (perfectly elastic: an elasticity of 1), than a raise in the minimum wage of $.01 would cause every minimum wage worker to lose their job. This is clearly not the case. If labor demand was completely insensitive to the price of labor (perfect inelasticity: an elasticity of 0), that would mean that workers were so vital to business operations that you could raise the minimum wage to 13 ka-billion dollars per second and nobody would lose their job.
It is important to know that labor demand is neither perfectly elastic or inelastic. Just how much labor demand is determined by the wage rate is the crux of the debate. More sensitivity to price would argue against raising minimum wages, because it would suggest unemployment. Consenus among economists, however, seems to be that there is relatively little price sensitivity in the demand for low wage workers, which suggests that if the minimum wage was raised, the businesses would simply pay that money to the workers, and there wouldn't be too much affect on employment.
BUT,
(if you thought I was going to support minimum wages, you were wrong.)
this is not the whole story. Let's first talk about the living wage. The living wage is not a small increase in the minimum wage--it's a big increase! Like a 40% increase! Labor demand is not perfectly inelastic--if you mandate the price of labor to be 40% higher, there WILL be unemployment. No doubt about it. The living wage is a blatantly detrimental market distortion.
Now let's talk about even a small increase in the minimum wage. Even if demand for low wage labor is relatively insensitive to price increases, businesses are not. If a business makes less money because it has to pay its workers more, there will be consequences. One or more of the following things would happen:
-The business will reduce its capital investment. With less profit, businesses are receiving a lower return on their investment and are less likely to invest in capital for the future. In the long run, this hinders the productivity of the business, and the business would hire fewer people than it otherwise would have. So while 100 people may be making $8 an hour, you could have had 110 people making $7.50 an hour. I would argue that the latter is better.
-The business will close. Small operations that hire mainly low wage workers may decide that they no longer want to deal with the hassle. Perhaps more likely is that the possibility that business owners will shift their operations to deal with higher wage employees so that what they are paying for labor is equal to the value of the labor. (This is exactly what happened with services: as sales taxes increase, business shift their resources to providing services to minimize taxes, and many of the taxable things {cars, happy meal toys, dog food, whatever} are produced in other countries.) In such a case, the very people that you are trying to help would be out of work.
-The business raises the price of what it is selling. In this case, Joe Average is worse off because he has to pay more for this product and has less money to spend on everything else. Furthermore, since the price of the product is going up, some people will decide that they no longer wish to buy this product, the business will make even less money, and these effects will continue.
So my point remains: minimum wages are bad, and living wages are criminal.
I would be fair in saying that my earlier statement condemning the minimum wage was valid, although Dr. Montgomery would maintain that a net benefit of a small minimum wage increase is slightly more likely than what I would claim.
The classic model of economics dictates that as any product or service becomes more expensive, the demand for that product will be decreased. Labor is no different--if wages are higher, there will be less demand for labor, and unemployment will result.
Neo-classic economic arguments focus on the elasticity of labor demand, which means how sensitive labor demand is to price fluctuations.
If demand for labor is completely determined by the price of the labor (perfectly elastic: an elasticity of 1), than a raise in the minimum wage of $.01 would cause every minimum wage worker to lose their job. This is clearly not the case. If labor demand was completely insensitive to the price of labor (perfect inelasticity: an elasticity of 0), that would mean that workers were so vital to business operations that you could raise the minimum wage to 13 ka-billion dollars per second and nobody would lose their job.
It is important to know that labor demand is neither perfectly elastic or inelastic. Just how much labor demand is determined by the wage rate is the crux of the debate. More sensitivity to price would argue against raising minimum wages, because it would suggest unemployment. Consenus among economists, however, seems to be that there is relatively little price sensitivity in the demand for low wage workers, which suggests that if the minimum wage was raised, the businesses would simply pay that money to the workers, and there wouldn't be too much affect on employment.
BUT,
(if you thought I was going to support minimum wages, you were wrong.)
this is not the whole story. Let's first talk about the living wage. The living wage is not a small increase in the minimum wage--it's a big increase! Like a 40% increase! Labor demand is not perfectly inelastic--if you mandate the price of labor to be 40% higher, there WILL be unemployment. No doubt about it. The living wage is a blatantly detrimental market distortion.
Now let's talk about even a small increase in the minimum wage. Even if demand for low wage labor is relatively insensitive to price increases, businesses are not. If a business makes less money because it has to pay its workers more, there will be consequences. One or more of the following things would happen:
-The business will reduce its capital investment. With less profit, businesses are receiving a lower return on their investment and are less likely to invest in capital for the future. In the long run, this hinders the productivity of the business, and the business would hire fewer people than it otherwise would have. So while 100 people may be making $8 an hour, you could have had 110 people making $7.50 an hour. I would argue that the latter is better.
-The business will close. Small operations that hire mainly low wage workers may decide that they no longer want to deal with the hassle. Perhaps more likely is that the possibility that business owners will shift their operations to deal with higher wage employees so that what they are paying for labor is equal to the value of the labor. (This is exactly what happened with services: as sales taxes increase, business shift their resources to providing services to minimize taxes, and many of the taxable things {cars, happy meal toys, dog food, whatever} are produced in other countries.) In such a case, the very people that you are trying to help would be out of work.
-The business raises the price of what it is selling. In this case, Joe Average is worse off because he has to pay more for this product and has less money to spend on everything else. Furthermore, since the price of the product is going up, some people will decide that they no longer wish to buy this product, the business will make even less money, and these effects will continue.
So my point remains: minimum wages are bad, and living wages are criminal.
Friday, September 28, 2007
The Benefits of Greedy Corporations
On more than one occasion I have used this blog to profess my platonic love of Walter Williams, and I can still say that I have not disagreed with him at any point during our affair. Mr. Williams usually writes about national issues, but his most recent column applies to some of the points that have been made on this blog.
(I wish that The Capital would publish a Walter Williams column every day. If he needs a day off, they can just publish one of his old columns backwards, and I will gladly read it using a mirror, because I am certain that such an exercise would be the most enjoyable use of my time.)
I have made the argument that businesses are not stupid, nor are they evil. Labor theory dictates that a person is paid roughly what they are worth, and I can assure you that if a business thought that it didn’t have to pay its CEO $20 million per year, it wouldn’t.
Mr. Williams offers an elaboration:
(People display) the anti-market bias—the failure to believe that market forces determine prices. Many believe that prices are a function of conspiracies by the chief executive officers of corporations—that if a CEO wakes up feeling greedy, he’ll raise prices.
They also believe that profits are undeserved, failing to see that, at least in open markets, profits are incentives for firms to satisfy customers, cut production costs, and move resources to the most efficient uses.
I am an amateur economist, but this guy is a PhD economist. If you don’t believe me, listen to him.
(I wish that The Capital would publish a Walter Williams column every day. If he needs a day off, they can just publish one of his old columns backwards, and I will gladly read it using a mirror, because I am certain that such an exercise would be the most enjoyable use of my time.)
I have made the argument that businesses are not stupid, nor are they evil. Labor theory dictates that a person is paid roughly what they are worth, and I can assure you that if a business thought that it didn’t have to pay its CEO $20 million per year, it wouldn’t.
Mr. Williams offers an elaboration:
(People display) the anti-market bias—the failure to believe that market forces determine prices. Many believe that prices are a function of conspiracies by the chief executive officers of corporations—that if a CEO wakes up feeling greedy, he’ll raise prices.
They also believe that profits are undeserved, failing to see that, at least in open markets, profits are incentives for firms to satisfy customers, cut production costs, and move resources to the most efficient uses.
I am an amateur economist, but this guy is a PhD economist. If you don’t believe me, listen to him.
Thursday, September 27, 2007
We Needn't Regulate Taxi Cabs
As you now know, we have higher taxi rates here in Annapolis. Alarmingly, in her letter supporting the rate increase, transportation director Danielle Matland had this to add:
As the City is supporting the taxi industry in its request for a rate enhancement, this would be a good time to implement additional requirements for the industry. This year, in cooperation with the AACVB, we are conducting voluntary Customer Service training for the taxi industry. Customer service training or similar training should be a requirement for all taxi drivers. It would be onerous and costly to for (sic) to provide a constant series of classes for incoming drivers. A practical method of implementing this beneficial training to enhance the industry would be to add a continuing education requirement as a condition of permit renewal. This Department would coordinate appropriate presentations or the taxi driver would have the option of selecting and documenting attendance in a course of their own choosing.
This is a perfect illustration of government mis-regulation of private industry, and the attitude of the regulators that stems from such abuse of market power.
Since the city of Annapolis regulates the rates cabs can charge, they are in entire control of the cab industry--they can make or break cab companies in a more efficient way than they can make or break the rest of us. The cab companies practically had to beg for a rate increase just so they could stay in business! And how does Ms. Matland respond.....she basically says "We've got them by the balls! Now is a great time to add more restrictions and requirements to the permit process."
Un-freeking-believable!
The government has no right to mandate "customer service training" for private cab companies! They shouldn't even be wasting taxpayer money to offer voluntary classes! Every other private company is responsible for training their own employees--if they think a certain training will be profitable, they will do it. But since the city controls how much profit cab companies can make, they must assume the burden of the training! What if the city did this for every industry. Balderdash!!
Now, don't get me wrong--taxi cab regulation is useful (although perhaps not necessary). They have a unique ability to usurp people who are very vulnerable and susceptible to such abuse, as users of cabs often don't know how much a certain trip 'should' cost, and information that would compare a particular cab to its competitors is hard to come by.
Notice, the problem is informational--it it prohibitively hard for people to ascertain the rates being charged by their cabbie in relation to those of another. However, you do not have to regulate prices to fix this problem.
Allow me to offer an alternative solution. The city can require that every cab paint on its doors, in 36 inch letters, the drop charge, per mile rate, and per hour rate. This would allow the free-market principles that guarantee efficiency to be upheld. Taxi cabs could charge whatever they want, and people could make a decision based on price and any other factors as to which cab they want to take. Before long, a going rate for cabs would be established, as cabs charging a higher rate would not get any passengers.
Moreover, this would save this taxpayers money. Currently, city staff must monitor the price of gas and send out notices when gas prices reach certain benchmarks, as fuel surcharges kick in after that point. They also spend time administering the aforementioned driver sensitivity programs, or whatever. Here's an idea: let the private market take care of its own business, and cut some unnecessary jobs in the process!
The attitude of the Annapolis government is unacceptable. Instead of exerting more and more control over private industry, how about letting them decide what is right for themselves? It would work out better for all of us.
As the City is supporting the taxi industry in its request for a rate enhancement, this would be a good time to implement additional requirements for the industry. This year, in cooperation with the AACVB, we are conducting voluntary Customer Service training for the taxi industry. Customer service training or similar training should be a requirement for all taxi drivers. It would be onerous and costly to for (sic) to provide a constant series of classes for incoming drivers. A practical method of implementing this beneficial training to enhance the industry would be to add a continuing education requirement as a condition of permit renewal. This Department would coordinate appropriate presentations or the taxi driver would have the option of selecting and documenting attendance in a course of their own choosing.
This is a perfect illustration of government mis-regulation of private industry, and the attitude of the regulators that stems from such abuse of market power.
Since the city of Annapolis regulates the rates cabs can charge, they are in entire control of the cab industry--they can make or break cab companies in a more efficient way than they can make or break the rest of us. The cab companies practically had to beg for a rate increase just so they could stay in business! And how does Ms. Matland respond.....she basically says "We've got them by the balls! Now is a great time to add more restrictions and requirements to the permit process."
Un-freeking-believable!
The government has no right to mandate "customer service training" for private cab companies! They shouldn't even be wasting taxpayer money to offer voluntary classes! Every other private company is responsible for training their own employees--if they think a certain training will be profitable, they will do it. But since the city controls how much profit cab companies can make, they must assume the burden of the training! What if the city did this for every industry. Balderdash!!
Now, don't get me wrong--taxi cab regulation is useful (although perhaps not necessary). They have a unique ability to usurp people who are very vulnerable and susceptible to such abuse, as users of cabs often don't know how much a certain trip 'should' cost, and information that would compare a particular cab to its competitors is hard to come by.
Notice, the problem is informational--it it prohibitively hard for people to ascertain the rates being charged by their cabbie in relation to those of another. However, you do not have to regulate prices to fix this problem.
Allow me to offer an alternative solution. The city can require that every cab paint on its doors, in 36 inch letters, the drop charge, per mile rate, and per hour rate. This would allow the free-market principles that guarantee efficiency to be upheld. Taxi cabs could charge whatever they want, and people could make a decision based on price and any other factors as to which cab they want to take. Before long, a going rate for cabs would be established, as cabs charging a higher rate would not get any passengers.
Moreover, this would save this taxpayers money. Currently, city staff must monitor the price of gas and send out notices when gas prices reach certain benchmarks, as fuel surcharges kick in after that point. They also spend time administering the aforementioned driver sensitivity programs, or whatever. Here's an idea: let the private market take care of its own business, and cut some unnecessary jobs in the process!
The attitude of the Annapolis government is unacceptable. Instead of exerting more and more control over private industry, how about letting them decide what is right for themselves? It would work out better for all of us.
Tuesday, September 4, 2007
Employer Paid Health Insurance: Child of the Liberal Mind
(Crossposted)
Many jobs these days--especially those filled by college graduates--offer health insurance and other benefits as part of a routine compensation package. I would argue that this is not good, and it certainly was not always so.
While the concept of health insurance dates back a few hundred years, employer-paid health insurance is decidedly a 20th century concept. Even then, most Americans did not have health insurance, and the ones that did had insurance only for emergency problems that would result in a permanenent disability.
So, what caused the 'benefits revolution'? A liberal midset!!! In its omnipotence, the government decided to freeze wages during World War II as an inflation fighting measure. Any time the government interferes with a free market, a black market develops. Look no farther than the illicit drug market in the United States to see that the government cannot change the laws of supply and demand--at least not without a sever restriction of freedom.
So what happened when the goverment tried to control the labor market during WW II? A black market for labor developed. Employers, struggling to attract workers, HAD to offer benefits in lieu of pay to find employees, since the benefits were not subject to the wage freezes. And, since wages are subject to employment taxes whereas benefits are paid pre-tax, there is further financial incentive for employers to pay in the form of benefits.
Once the war ended, union collusion ensured that such benefits would remain a permanent part of American business life. It is reasonably fair to say that the philosphies of big government and imperfect markets have paved the way for the health care system as we know it today.
So why are benefits inferior to straight monetary payemt? The answer is restriction of choice. For each employee hired, an employer determines the total compensation (salary and benefits) that the particular employee will receive. Let's say that you are worth $100,000 per year to your employer. Let's further stipulate that your compensation consists of $80,000 in salary, and $20,000 in the form of health insurance that the company pays for you.
As Nobel Laureate Milton Friedman points out, economic freedom is essential to political freedom. In your case, you do not have the choice as to how to spend your $100,000. You get health insurance and $80,000. What if you are a healthy person? You don't smoke, you don't drink, you don't listen to talk radio, etc. Since you are healthier than the average person, you could get health insurance for less than $20,000--let's say $15,000. So, if you received your $100,000 all in the form of cash, you could get health insurance and have $85,000 to spend, not $80,000. As you can see, this process distorts the market result and in some (perhaps most) cases results in an unfavorable outcome.
Time and time again, government policies to control markets result in unintended consequences that affect our lives negatively for years to come.
Many jobs these days--especially those filled by college graduates--offer health insurance and other benefits as part of a routine compensation package. I would argue that this is not good, and it certainly was not always so.
While the concept of health insurance dates back a few hundred years, employer-paid health insurance is decidedly a 20th century concept. Even then, most Americans did not have health insurance, and the ones that did had insurance only for emergency problems that would result in a permanenent disability.
So, what caused the 'benefits revolution'? A liberal midset!!! In its omnipotence, the government decided to freeze wages during World War II as an inflation fighting measure. Any time the government interferes with a free market, a black market develops. Look no farther than the illicit drug market in the United States to see that the government cannot change the laws of supply and demand--at least not without a sever restriction of freedom.
So what happened when the goverment tried to control the labor market during WW II? A black market for labor developed. Employers, struggling to attract workers, HAD to offer benefits in lieu of pay to find employees, since the benefits were not subject to the wage freezes. And, since wages are subject to employment taxes whereas benefits are paid pre-tax, there is further financial incentive for employers to pay in the form of benefits.
Once the war ended, union collusion ensured that such benefits would remain a permanent part of American business life. It is reasonably fair to say that the philosphies of big government and imperfect markets have paved the way for the health care system as we know it today.
So why are benefits inferior to straight monetary payemt? The answer is restriction of choice. For each employee hired, an employer determines the total compensation (salary and benefits) that the particular employee will receive. Let's say that you are worth $100,000 per year to your employer. Let's further stipulate that your compensation consists of $80,000 in salary, and $20,000 in the form of health insurance that the company pays for you.
As Nobel Laureate Milton Friedman points out, economic freedom is essential to political freedom. In your case, you do not have the choice as to how to spend your $100,000. You get health insurance and $80,000. What if you are a healthy person? You don't smoke, you don't drink, you don't listen to talk radio, etc. Since you are healthier than the average person, you could get health insurance for less than $20,000--let's say $15,000. So, if you received your $100,000 all in the form of cash, you could get health insurance and have $85,000 to spend, not $80,000. As you can see, this process distorts the market result and in some (perhaps most) cases results in an unfavorable outcome.
Time and time again, government policies to control markets result in unintended consequences that affect our lives negatively for years to come.
Tuesday, July 17, 2007
Sister City Report
The mayor has posted her first non-biographical entry on her blog, http://www.ellenmoyer.blogspot.com/. The mayor visited Rochefort, France on July 16. We learn that this city is near the water, that shipbuilding is important, and that they 'brew' cognac there. How excellent.
Everyone should have a vacation, and the mayor's decsription of the city reminded me in a nostalgic way of my recent trip to Spain. The thing is, I went for 10 days during Thanksgiving--a time when not much work gets done anyway and me being gone only affects me--and the mayor is gone for 60 DAYS!, and her being gone affects some 30,000+ citizens, at least theoretically. For example, on the day when the mayor was learning the above facts,
-there were 122 calls to 911
-6 people were arrested
-we were in a traffic jam on forest drive, or west st., or near park place, or on chiquapin round rd.
-the air conditioning problem at market house still has not been solved
-there is no director of public works
-i slammed my finger in my car door, and it hurts
Oh well, nothing we can do about it now. Even if there was an emergency, the mayor has a no-air-travel policy so she wouldn't be back to help anyway.
Most of the post was somewhat mundane, but this particular section caused some alarms to sound:
I also learned that in Annapolis we rely far more on private contributions to support the simple things that bring pleasure in life like fireworks, gardens, art, celebrations like Charter 300 and major efforts in preservation. Public dollars are the major and sometimes only source of investment here.
Make no mistake, Annapolis spends a lot of $$$ on things that should be left to the private system. For goodness sake, we had better spend less than the French do. See, the thing is, the more you rely on the private market, the better you are.
Let's look at this very crude data:
France:
Corporate Income Tax Rate: 33.33%
Individual Income Tax Rate: 10% - 48.09%
Per Capita Gdp (a measure of wealth): $30,693 (2006 est)
Unemployment: 8.1%
United States:
Corporate Income Tax Rate: 35%
Individual Income Tax Rate: 0%-35%
Per Capita Gdp: $43,444 (2006 est)
Unemployment: 4.5%
Tax Rates are a reasonable signal of how much the government is involved in the economy. In france the government does more, and the economy is worse. In the United States, the private market does more, and the economy is better.
Let's get a little more scientific.
In 1989, two World Bank economists studied 106 countries for 34 years, and found that:
-For manufacturing based countries, those with higher than average use of free market principles averaged 5% annual GDP growth, and those with lower than average use of free market principles had 3.9% annual GDP growth.
-For natural-resource based countries, those with higher than average use of free market principles averaged 5.5% annual GDP growth, and lower than average use of free market principles: 4.7% annual GDP growth.
Free market = better than socialism, but only if you want more wealth (or more political freedom).
Also, in 1995 two Harvard economists concluded that the way for poor countries to get wealthier and perhaps catch up to rich countries was to have a more open trade and protect property rights. Imagine that: a place where the government doesn't interfere with business, rights are protected, and laws are enforced. Brilliant!
Now, the mayor was probably not considering these things, but I think it shows the fundamental difference in political philosophies between liberals and conservatives, and in my opinion that conservatism is superior. Superior based on fact and data.
Everyone should have a vacation, and the mayor's decsription of the city reminded me in a nostalgic way of my recent trip to Spain. The thing is, I went for 10 days during Thanksgiving--a time when not much work gets done anyway and me being gone only affects me--and the mayor is gone for 60 DAYS!, and her being gone affects some 30,000+ citizens, at least theoretically. For example, on the day when the mayor was learning the above facts,
-there were 122 calls to 911
-6 people were arrested
-we were in a traffic jam on forest drive, or west st., or near park place, or on chiquapin round rd.
-the air conditioning problem at market house still has not been solved
-there is no director of public works
-i slammed my finger in my car door, and it hurts
Oh well, nothing we can do about it now. Even if there was an emergency, the mayor has a no-air-travel policy so she wouldn't be back to help anyway.
Most of the post was somewhat mundane, but this particular section caused some alarms to sound:
I also learned that in Annapolis we rely far more on private contributions to support the simple things that bring pleasure in life like fireworks, gardens, art, celebrations like Charter 300 and major efforts in preservation. Public dollars are the major and sometimes only source of investment here.
Make no mistake, Annapolis spends a lot of $$$ on things that should be left to the private system. For goodness sake, we had better spend less than the French do. See, the thing is, the more you rely on the private market, the better you are.
Let's look at this very crude data:
France:
Corporate Income Tax Rate: 33.33%
Individual Income Tax Rate: 10% - 48.09%
Per Capita Gdp (a measure of wealth): $30,693 (2006 est)
Unemployment: 8.1%
United States:
Corporate Income Tax Rate: 35%
Individual Income Tax Rate: 0%-35%
Per Capita Gdp: $43,444 (2006 est)
Unemployment: 4.5%
Tax Rates are a reasonable signal of how much the government is involved in the economy. In france the government does more, and the economy is worse. In the United States, the private market does more, and the economy is better.
Let's get a little more scientific.
In 1989, two World Bank economists studied 106 countries for 34 years, and found that:
-For manufacturing based countries, those with higher than average use of free market principles averaged 5% annual GDP growth, and those with lower than average use of free market principles had 3.9% annual GDP growth.
-For natural-resource based countries, those with higher than average use of free market principles averaged 5.5% annual GDP growth, and lower than average use of free market principles: 4.7% annual GDP growth.
Free market = better than socialism, but only if you want more wealth (or more political freedom).
Also, in 1995 two Harvard economists concluded that the way for poor countries to get wealthier and perhaps catch up to rich countries was to have a more open trade and protect property rights. Imagine that: a place where the government doesn't interfere with business, rights are protected, and laws are enforced. Brilliant!
Now, the mayor was probably not considering these things, but I think it shows the fundamental difference in political philosophies between liberals and conservatives, and in my opinion that conservatism is superior. Superior based on fact and data.
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