Rossputin.com Rational Thinking About Our World

One can hardly read or listen to any mainstream media without hearing a talking head ask at least one of the following questions:

1) Don't gas prices mean that oil companies are "gouging" consumers?
2) Don't oil company profits mean that the companies are "profiting off the misery of society"?
2) Should we consider price controls?
3) Why isn't the government doing anything about oil prices?

Let's address each of these examples of economic illiteracy.

1) Gouging: Gouging is close to impossible in a competitive market. The price mechanism is working properly as a way to allocate a scarce resource. When prices are rising, it means demand is increasing relative to supply. But that sort of dry economic argument only goes so far. What's really going on? First, the economy is doing great and there is a lot of demand for energy. Second, the Federal government has changed the rules about gas formulation, replacing one additive (MBTE) with another (ethanol). There are many refineries who have not yet converted all their refining capacity from MBTE to ethanol, so they are unable to produce as much gasoline as they could before and will be able to again in the future.

So, the current price simply reflects the balance between supply and demand. If the price were artificially forced lower, we would simply run out of gasoline because of some combination of refusal to produce it at lower prices and excess buying by customers. If there were actual gouging going on, the competitive nature of the marketplace would cause producers to produce more to capture the "excess profits" available, thus forcing the price down. The price of gasoline, while painful, simply reflects economic reality.

2) Oil company profits: A local radio talk show host (a very smart guy) spent much of the afternoon yesterday wondering aloud why oil company profits are going up with the price of gasoline. He and a couple of callers theorized that profits in many businesses are proportional to the price of the thing being sold, so that profits would go up somewhat with gas prices but not enough to explain the companies' enormous profits. I called in and explained to him what should have been obvious: Most oil companies own oil! They are not simply middle-men who buy oil from the Saudis and refine it. They spend billions of dollars finding and drilling for their own oil; thus the price of oil going up means they make more money.

Yes, consumers everywhere use oil and oil-related products and thus it is true that the oil companies make more money because consumers are paying more for oil, directly or indirectly. However, the nature of any market as enormous as the oil market is that the producers (even OPEC, but particularly individual companies no matter how large) have only a small ability to effect the price of the commodity. Oil is a world-wide actively traded fungible product. Anyone from a producer to a consumer to a speculator can trade in oil, with the net effect of all these participants being the setting of an at-least-temporary market-clearing price. The ability of ExxonMobil to effect this price is very slightly more than zero.

Be very clear here: The only reason you have access to oil and gasoline is because it is possible to profit by producing it.

More on profits in a minute....

3) Price controls: Price controls on gasoline would certainly accomplish a few things: A massive shortage of gasoline and a black market for gasoline with much higher prices than we have now. Nixon tried price controls on oil, and if you do some research, you'll see they were a massive failure. It is only because our current crop of politicians are so blissfully unaware of history or economics that anybody even suggests price controls.

A relevant anecdote comes to mind: A friend (known on this blog as "The Freak") and I were travelling in the Soviet Union. We needed some gasoline for a scuba compressor so we suggested to our Russian hosts that we got to the nearest town, where we had seen plenty of cars driving around, and pay someone an extra buck or two for some gas. Of course, the government set price controls on everything in the USSR, so the absolutely classic response we got was "Gasoline is very cheap in Kandlaksha. You just can't buy any."

That's all you need to know about price controls.

4) What should government do? OK, back to profits for a minute. The question about oil company profits is always asked in a way which implies that the companies are evil, that profits are evil, and that if the companies were good citizens, they would just charge less. Let me put this another way: Let's say you buy a house as an investment for $250,000 and it increases in value to $500,000. Then lots of people decide they want houses but they think $500,000 is too much. Not only do they think it's too much, but they want YOUR house. How fair would it be for government to suggest that the price of your house obviously went up too much because many people want to buy it...just for less than you can get for it? How fair (or damaging to your net worth) would it be for the government to say that to solve the "problem", you either may not sell your house for more than $400,000 or you must pay a 20% "windfall profits" tax when you sell the house?

Oil companies make money for the same reason you would on your house: because they spent time and money investing in the hope of a profit opportunity later.

Not only should the government do nothing in this situation (other than stop micromanaging fuel additives), they should aggressively come out and say that they will do nothing in the area of price controls or windfall profits taxes. Put it this way: How much less would you invest in a house if you knew there were a real chance that any profit you made would be limited or massively taxed? Oil companies work the same way. The threat of price controls and extra taxes crush any incentive for bigger investment in finding and developing new sources of oil.

So, not only do government interventions in free markets have only bad effects, but even the threat of interventions do.

Sorry, Virginia, there is no oil Santa Claus. There is no way to force the price down through command and control measures. The price will come down when supply begins to exceed demand at the margin. If you want to help that happen, buy a more fuel-efficient car, washing machine, or private jet. Encourage conservation and alternative energy sources (but only ones which are viable without subsidies). Carpool or take one less unnecessary drive to a shop. But leave the government out of it. If we learn anything from history (and clearly our elected officials don't) it is that government interference in competitive markets does not achieve its stated goals...but at least it has terrible unintended consequences.