Economics for Unitarians

(and other people who don't know much about economics)

A look at incentives and disincentives in the Gasoline and Sugar markets (boy, that sounds exciting!) - an economic discussion intended to foster level-headed thinking about basic economic principles and their consequences

It's 2008. Oil and gas companies are making excessive profits and should be punished. What can be said about this? Any truth to it?

Some oil and gas companies are making large profits in absolute terms, yes, this is certainly true. But the main reason is because they are among the very largest companies in the economy; therefore it should come as no surprise that their absolute profits are among the largest. As these companies grow with the economy these absolute numbers will get bigger and bigger, thus they always have the potential to have the "largest corporate profits in history." The fact that a half-trillion dollar company has profits in the billions should not be terribly surprising. What may surprise a few people, though, is that these companies are contributing 3 times that amount in taxes.

But are they really "excessive profits?" What would constitute an excessive profit? In a free market, can there really be such a thing as excessive profits? What happens in a free market if there are excessive profits? (I'll get to these, but one step at a time).

In evaluating how a company is doing, we don't really care about the absolute level of profits; we care about the return on investment. That is, something along the lines of absolute profits divided by the equity invested, i.e. the percent return on investment. So what would be an "excessive" return on investment? 100%? 1000%? In order to count such profits as a "windfall," surely we're talking about such numbers, right?

Well, no. In this case we are talking about some oil companies that in some quarters are reaching the range of 15-20% annualized returns. These are decent profits, but um, excessive? If they were excessive, they would also likely be unprecedented, right? But the oil companies have made these same levels before, about 30 years ago. And many high tech companies like Apple regularly make profits of 40% or more, sometimes much more - should Apple be penalized for this?

On average the oil & gas companies make around 7.5%, sometimes lower, and yes, sometimes higher. As it happens, this 7.5% average return for the oil & gas sector is actually slightly less than the average return for all companies. And there are many large companies with multi-billion dollar profits (in the range of Exxon's) that consistently (not just intermittently like in oil & gas) make 12-15%, such as Citigroup. Should Citigroup then be penalized for "windfall" profits? After all, in many years Citigroup, not Exxon, has been the holder of the title “largest corporate profits in history.”

There are many contributing factors to oil company profits, but many people tend to focus on gasoline prices. Gasoline prices are set by supply and demand. The price of gasoline, adjusted for local factors (such as transportation and taxes) is historically nearly 100% correlated to the price of oil, although in this recent runup gasoline has actually lagged far behind the price of oil. According to this long standing correlation, the price of gasoline should actually be about twice as high.

Oil is a commodity. It doesn't matter if you ship it from Saudi Arabia or extract it from Rocky Mountain shale - there's just not much wiggle room on price. It's oil, and the price is mainly set by global supply and demand. The overwhelmingly significant factors are that worldwide demand continues to grow while worldwide supply has not kept pace. The result is that prices have gone up.

The vast majority of oil company revenue is reinvested in the search for more oil. If you cut back on oil company profits, you will cut back on exploration, which will reduce the future supply, and prices will go up.

Additional factors that affect the price of gasoline include regulations that require companies to make a number of rarely used “boutique” fuels, as well as the fact that gasoline bound for mixing with ethanol has to be kept separate from other gasoline, necessitating an independent distribution network. This is very costly.

Finally, it is important to keep an overall perspective. Although gasoline prices have gone up significantly in the past few years, inflation adjusted prices hit their lowest levels in history around 1998-1999, and disposable income has increased far more rapidly than gas expenses.

What about speculation?

Speculation has been mentioned as a factor in the oil price runup, with one Presidential candidate recommending we stop American citizens from trading in oil futures. There are several things wrong with this view.

Speculation is an integral part of every trading market. Short term traders freely take on positions that are risky in hopes of profit. The fact that a large number of people do this in oil futures is not unusual. It is the same in all futures markets. For example, the majority of stock index futures contracts are typically held by speculators, who do a great service to you by providing liquidity. Traders such as these allow you to often buy stocks, futures, and options within a fraction of a second.

And speculation is speculative. It's not a sure thing. Sure, you can buy (demand) an unusually large amount of oil futures, but since for every contract bought, one must be sold, you would be asking sellers to go out of their way to meet this unusual demand. In response the sellers will require that you pay more than normal, so yes, that does work to bid up the price - but only in the short run. The problem is that you will have to exit your position at some point in time, and your selling will then cause the reverse effect on prices - they will be offered down. And it's one thing to talk about short term, say intraday, manipulation, and quite another to talk about propping prices up for months and years. Futures contracts are limited in duration - they expire and they must be sold. If all you are doing is bidding up prices speculatively, your only real hope is that you can pass what is essentially a “burning match” to someone else at a higher price, and hope they're the one that gets burned. Good luck with that.

Price levels do get out of whack sometimes. People get excited about things, they get into panics as well as euphorias. If you take a look at some long term multi-decade charts of various commodity prices you will soon understand. These things happen. Ultimately, though, the price level goes back to supply and demand factors. It can be no other way in the long term.

The idea of stopping speculation in oil by preventing Americans from speculating is quite insane in my view. Oil is a global commodity, with London being one of the major trading centers. If there were any American-specific manipulation, traders in London would be able to profit by arbitraging away the difference. Speculation on oil will not stop just because Americans are kept out of it. This to me is an extremely naïve notion that shows ignorance of global markets and basic economics, and takes the myopic view that America is the only country in the world.

So what's the deal with supply and demand anyway?

Supply and demand explain how markets set prices. The factors that contribute to a low relative price are large supply and small demand. Conversely, the factors that contribute to a high relative price are small supply and large demand. And at a basic level, as the price of something goes up, people tend to buy less, and as the price goes down, people tend to buy more. At this level it can almost be reduced to accounting, i.e. with $100 you can buy 10 widgets at $10 each, but if the price of widgets goes up to $11, you will only be able to afford 9 widgets. (This basic math explains why as minimum wage is raised, you increase unemployment at that wage level).

Economies of scale and transaction costs contribute to the fact that you can generally purchase widgets at a lower price if you are willing to buy a large quantity, while you may pay a higher price if you are purchasing only a single widget. And you can also talk about the relative elasticity or inelasticity of demand, which refers to the fact that changes in demand for unessential items will affect price more than changes in demand for essential items.

Economics is a soft science, but there are some basic principles that hold up quite well and the Law (not the Theory) of Supply and Demand is is one of them. Besides being intuitive and obvious, it holds up in all kinds of studies including cross-species studies on primates.

Despite the fact that more than 17 studies have shown no evidence of price-gouging, Democrats have passed legislation to increase the taxes on oil & gas companies. They have also talked about putting price caps on gasoline. How well have price controls and other types of economic meddling fared in the past?

Abysmally.

The basic economic lesson here is that price controls create shortages. One example was FDR's price controls on food during the Great Depression. During the discussion phase, hundreds of prominent economists signed a petition, telling Roosevelt that price controls never work and would create shortages, but to no avail. The result was that farmers found themselves faced with huge potential losses. In many cases, investing additional capital to harvest and take the crops to market for an artificially low price would have caused them to lose even more money, so they tilled their crops under in order to take a smaller loss. Literally millions of acres of perfectly good crops were plowed back into the soil, as well as millions of yearling hogs and other livestock that were slaughtered and buried. This was during a time when many people were going hungry.

During WWII we had price controls on wages. This restriction added to the labor shortage. A historical aside - it was during this time, in order to entice workers without violating those wage limits, that some employers began to offer free health insurance, paying for it by illegally deducting it as a business expense. It took the IRS a couple of years to figure this out, and populist politicians ended up letting the practice continue. This grandfathered-in third party payer system is the source of some inefficiencies and the lack of portability in health insurance, and created an unequal playing field for retirees and certain self-employed workers (like me) who are unable to fully deduct their health insurance costs, while most corporate employees get their healthcare tax-free.

And of course we've experimented with price controls on gasoline before - in the 1970s. The result was predictable - instant shortages of gasoline, with lines around the block, rationing, and a multi-billion dollar hit to the economy.

In the marketplace, prices provide valuable information. High gas prices signal consumers to reduce their consumption and conserve. Companies in businesses such as oil exploration are spurred to increase their efforts to bring oil to the market. New methods of oil extraction can be used that were unfeasible at lower prices, and alternative energy become more viable.

Under price controls, consumers are not moved to conserve, and you instantly make unprofitable the more expensive, marginally profitable ways of getting oil. The result is that companies can no longer afford to spend as much on certain kinds of oil exploration (and thus many specialized oil exploration companies will be forced completely out of business, as they were in the 1970s), which ultimately leads to a smaller supply of oil, which leads to higher prices. (Question - What happens when you put price controls on health care?)

What about other forms of meddling in the energy markets?

There are environmental concerns, but here we are focusing only on their economic effects. Currently we don't allow offshore drilling in certain parts of the Gulf of Mexico, one of the larger oil fields and one of the easiest to recover the oil from (the low hanging fruit). But the nationalized Mexican oil company is drilling (and other countries as well), and if you saw "There Will Be Blood," you will understand that what the Mexicans are saying to us is, "I drink your milkshake!" They are tapping into the same oil field that goes under our portion of the Gulf. They are drinking our milkshake, and whether we do it or the Mexicans do it, that oil will be drilled from offshore. We only have to decide if we'd like Americans to benefit from it or not. There are oil rigs in place off the coast of California that can be up and running in no time.

The really big potential in oil is from Rocky Mountain shale, possibly hundreds of years worth. But because it requires a bit more energy to extract than ordinary oil, and with the current attitude that it is unacceptable to use any more energy to extract oil than is currently used in ordinary drilling, and the federal government owning fully half of the land west of the Mississippi, it doesn't look like we're going to touch it and we may not even let ourselves buy it from Canada. There's over a trillion barrels we're thumbing our noses at, plenty enough to both keep high prices at bay and make our own way completely self-sufficiently while alternate energy sources are developed.

Energy-wise we also shoot ourselves in the foot with nuclear policy, which since the 1970s under Carter has banned the efficient recycling of nuclear waste (apparently due to fears that the plutonium could be used in dirty bombs). But we need to undo this law so that we can use the same type of highly efficient, low-waste nuclear energy that France and many other countries use.

So what about those excessive profits in a free market? And what about taxing away those excessive profits?

So-called excessive profits in a free market have an extremely important function - they tell people exactly where to invest capital. To an entrepreneur, profits are like a beacon that tells them where to invest and thus create competition. They see an industry with high profits and they want to capture these profits, so they go into this business, creating additional supply and competition. The competition causes the profit margins to go down and the industry eventually becomes "mature" with only average profits. This is part of the well known life cycle of an individual company or industry. The entrepreneur then sells the mature company and moves onto the next new venture. In this way they keep average prices down and end up supplying consumers with exactly what they want. There really can't be sustained excessive profits as long as the market is relatively free. The only way that there can truly be excessive profits is where the government has intervened and is preventing competition (for example, the FDA creates this situation in the pharmaceutical industry). The sole remedy is to remove the government's restrictions.

If you instead take away the excess profits, you take away the entrepreneur's incentive. They will not enter the market, they will not compete, they will not introduce additional supply, and prices will remain high. In the case of oil & gas, one bottleneck is refining capacity. Refineries are prohibitively expensive, time consuming to build, generally not that profitable until recently, and local environmental concerns have all but prevented any new refineries from coming online. Taking away the "excess" profits will absolutely ensure that there is no new competition and no new refineries will be built. Prices will remain high.

What are the effects of subsidies and taxes?

In economics there are a couple of sayings, "whatever you subsidize, you get more of" and "whatever you tax, you get less of." A subsidy is an incentive, and a tax is a disincentive. If you subsidize say, the building of oil refineries, you will get more oil refineries and this can help lead to lower gas prices. Actually this an ideal use for government, a so-called unmet need in the marketplace (of course, in this case it is unmet precisely because of local government restrictions). If you tax oil companies, you will get less in the way of oil companies. You ensure that competitors will not enter the market and this will lead to higher gas prices. (Questions - What happens when you excessively subsidize the poor? What happens when you excessively tax the rich?)

I am not personally in favor of "social engineering," but one example where the government at least gets the direction right is that they heavily tax cigarettes. They want less smoking, so they tax tobacco. This is correct logic, at least. On the subsidy side, it gets difficult. Subsidizing alternate forms of energy may make some sense on the surface, but these subsidies tend to be set up to cater to special interest groups (i.e. corn farmers and ethanol) like everything else. And you have to make the rather incredible assumption that government can actually see into the future and predict which area will be the right one to invest in. Wall Street is full of a lot of extremely smart and industrious people that have failed at exactly that task.

For example, currently by its subsidies the US government is making the prediction that ethanol is the wave of the future, i.e. that's where we should invest a lot of our resources. But unless something spectacular occurs with cellulose, this corn-based subsidy is a government boondoggle if there ever was one. The money goes to corporate agribusiness, the regulations for ethanol increase our gasoline prices, and the artificial demand created by the ethanol subsidy is raising the price of agricultural products around the world and literally causing people in third world countries to starve.

Of course subsidies are not really part of the free market - what is their overall effect?

In a free market, resources are allocated very efficiently. When you go to the grocery store or to a restaurant, you are voting for what foods you would like to be produced, in what quantities. This information gets to the farmers who decide what and how much they grow. In the absence of interference, it will be found that the farmers on average learn to get the most productive use out of their land. No centralized system has ever been found to be superior to the free market for this type of allocation of resources. This is very much in line with recent ideas about so-called “emergent behavior” that have led to highly accurate market based predictions in a number of areas, one being elections.

So the free market creates an optimum allocation whereby the farmers are producing the maximum value for themselves, which as it turns out also produces the maximum value for consumers. But then a group of farmers, let's say corn farmers, petition the government for subsidies. Once the subsidy is in place, the farmers will re-allocate accordingly. What you subsidize, you get more of, so now you get more people growing corn. But notice that production of value is no longer the farmers main concern as the government has now turned this into an artificial economic decision. They were being optimally productive, but now some farmers will be lured away from optimum productivity by the subsidy. And we all end up paying for it. The cost therefore is double what you might think - because we not only move the farmers away from optimum productivity and thus have that loss of value, but then we also have to pay them to do it. Every subsidy causes the country as a whole to produce less value, plus we have to actually pay for this decrease in value to occur. The less value we produce, and the more we have to pay for it, the smaller is the pie from which we all have to live.

Don't some industries need a helping hand? What happens to industries that are in trouble that get subsidized?

Generally speaking, they get into even more trouble. Industries get in trouble from time to time, this is reality. If foreign competition comes up with a new and better manufacturing technique, there is only one true solution - the domestic company must step up to meet the new competition. When they don't, when they turn instead to the government for help, they end up being coddled. With the help of a subsidy, the company doesn't have to step up - they can continue using old technology, etc., and typically that's exactly what they do. Their incentive to compete at the highest level is gone, and so the company falls even further behind the competition. This has happened in many formerly US dominant industries including televisions and cars. In these two industries penalties (i.e. tariffs) against foreign competition were/are used instead of domestic subsidies, and this generally causes the foreign competition to become more competitive - they either learn to compete with the tariff in place, or they go out of business. Not surprisingly, they generally learn to compete.

Often these subsidies are given on a "temporary" basis but like most government actions they are virtually never removed. The steel industry talked the government into subsidies back in the 1800s, and it is still subsidized.

What are the specific effects of agricultural subsidies, say, the sugar subsidy in particular?

Sugar farmers (cane and beet) got sugar subsidized back in the 1930s. Since then, we all pay 2-3 times the world price for sugar as a result, and thus any domestically produced product that contains sugar is more expensive as a result. In combination with the corn subsidy, this is why high fructose corn syrup became so successful - high sugar prices made it easy for corn syrup to compete. The sugar subsidy, like many other agricultural subsidies, goes mainly to a small group of very large farmers and operates more or less like a sugar "cartel" that benefits greatly from public funds at our expense.

The sugar subsidy requires around $1.7 billion a year, while the increased cost to consumers is an additional $1.9 billion. And as big as those costs are, the total costs turn out to be even more far reaching. For example, although many candy manufacturers held on for quite a while, as a country we have lost almost all of them. It is very simple - if you are a global business based in the US, and the US makes your raw material 3 times more expensive than anywhere else in the world, you are an idiot if you remain in the US. As a result, virtually all the major candy and sugar based product manufacturers that were in the US have moved to Mexico and Canada. We have lost thousands of jobs, with big names like Hershey's, Brach's, Nestle's and Lifesavers, to name just a few.

In addition, there is a huge amount of environmental damage being done as a result of agricultural subsidies. We are overfarming the land, depleting it of valuable minerals, with the result that our food has less nutritional value. As a result of subsidies, more land is used farming, and that land is fertilized to a much greater degree than it would be otherwise, causing the soil to become laden with fertilizer salts. This is why the sugar subsidy, responsible for the great expansion of sugar farming in south Florida, is the single largest environmental challenge to the Everglades.

Also, our subsidies take away from many third world countries that would be ideal places for agriculture, with good climates, cheap land and cheap labor. But because of heavy US and European subsidies, third world countries simply cannot compete on agriculture. To the extent that we subsidize our agriculture, we kill agriculture around the world. And we subsidize many of these same third world countries with financial aid (which is generally more of a subsidy for their dictators and governments than their people), when instead we could provide a better overall benefit for the world and ourselves by removing our subsidies and letting other countries grow their own food and make their own money.

Eliminating agricultural subsidies (there are over 2 dozen markets "in play") will not eliminate farming in the US. Yes, some farmers will likely go away - this is because they will need to find something to do that actually produces real value - but of course this is a good thing. In New Zealand in 1984, they removed all of their very complex system of agricultural subsidies - all of them, cold turkey. Although the results of many of NZ's overall reforms from that time are controversial, in the agricultural industry this led to general acclaim. Less than 1% of NZ farmers went out of business, (an amount that might have gone out of business anyway) while production increased.

What is the point about all this talk about economics?

It is an attempt to give people a feel for how things work, with the goal of getting people to judge a government policy not based on the mere "feel good" intentions of a policy as is often done, but on the actual real world results of the policy. And not just the results in the short term on a chosen special interest group, but rather the totality of results in the long term on the entire economy. It's about taking a hard look at the unintended consequences of a policy, and understanding the real world pros and cons. Good intentions are nice, but ultimately meaningless.

How might I learn more about economics?

I'd recommend Economics in One Lesson by Henry Hazlitt, or maybe Free to Choose by Nobel Prize winning economist Milton Friedman. Although both of those are readable, I do have a pair of alternate suggestions that might be a bit more fun, even beach-worthy. For the purposes of learning a bit about economics in a somewhat indirect way, I would give my highest recommendation to a couple of very entertaining travelogues that are permeated with basic economic principles, world history and geography, and painlessly teach much about the way the economic world actually works (as opposed to the way that academics and world leaders may think or intend). They are:

Investment Biker: Around the World with Jim Rogers and Adventure Capitalist: The Ultimate Road Trip

These books are by Jim Rogers, a small town boy from Demopolis, Alabama (growing up, his family's phone number was "5") who after going to Yale and Oxford became George Soros' right hand man during the heyday of the renowned Quantum Hedge Fund. He retired at 37 and continued investing on his own, with a peculiar interest in investing around the world gathering knowledge quite literally from the ground up. He describes circumnavigating the globe, going through almost every country, first by motorcycle, and in the second book another complete circumnavigation in a custom off-road Mercedes, with both trips qualifying as Guinness World Records. His fascinating accounts weave incredible stories, a love of travel and hair-raising adventure (often in legitimately life threatening situations), interspersed with small doses of his valuable perspective on world history and economics, and his knowledge is deep. You have to love a guy who takes government statistics with a grain of salt - rather than trust the official exchange rates, he always goes amongst the people and bargains with them for the local currency to see what the true value is on the black market. As a result of his travels he has moved to Singapore and is seeing to it that his daughter grows up speaking Mandarin as well as English. Great, great stuff that I intend to read again.

Also, a good place for many to get a different viewpoint might be Cato, a thinktank that represents a more Libertarian perspective emphasizing freedom as the basis of a civilized society. Search on a specific issue of interest, and read a couple of papers. For example, I recently found an interesting paper on public health policy (Parasites, Profits, and Politicians) that explored the role of economic growth (as opposed to public policy) in the decline of mortality. I mention this partly because it is worth mentioning that economic growth is the poverty killer.

I also recommend the Carpe Diem Blog, an economics blog that is quite good for a different viewpoint, although some will bristle at the conservative bias.

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