“Teach a parrot how to say the terms, ‘Demand and Supply,’ and he’ll think he’s an economist.”
October 4, 2008 — I had just started introducing the subject of the day’s lesson to my high school economics students when I noticed one of our vice principals standing just inside the classroom entrance – there for what reason I did not know. I caught his eye, anticipating that he needed to see one of my students for something. But when he said nothing, I decided that he was just stopping by to observe. Accordingly, I continued with my introduction.
“With the price of oil down now to around a hundred dollars a barrel, why are gas prices still so high? I thought you told us last week that when the price of production inputs fall, producers will produce more.”
“Thank you for the question, Tra’Nisha,” I said. “It’s a good one, but recall all that I said… that producers will normally produce more when the price of production inputs fall. The Law of Supply, you see, is not infallible. It’s not a hard-and-fast law. The reason for this is that markets are not all alike. In markets with less than sufficient supplier competition, Adam Smith’s invisible hand is hindered; it doesn’t work like it should.
“Less than sufficient supplier competition? I don’t get it,” said Tra’Nisha;” there are lots of different gas stations.”
“Yes, Tra’Nisha… but most of these are independent retailers. They buy their gas and other petroleum products from one of the few big oil companies still doing business in the United States – Exxon/Mobile, Chevron/Texaco, Conoco/Philips, Dutch Royal Shell and British Petroleum, all of which have vertically aligned business models. They control all aspects of production, from resource exploration, drilling and recovery, to transportation, to refining and finally, to distribution. It is these, the wholesalers, more so than the retailers, who set the price. The retailers just add-on to wholesale prices what they need add so as to make a small profit and still be competitive in their communities. The big profits are retained farther “upstream” by the majors, and they, few as there are anymore, are able to control wholesale prices with interdependent behavior by controlling supply. This interdepen- dent behavior is called collusion. We’ll get into this more in a later lesson on competition and market structure. But when only a few large businesses dominate an industry like petro-chemical, it’s called an oligopoly.
“So what is the problem, Mr. Garry?” this from the vice principal who was still standing just inside the doorway. “Is it a supply problem?”
“No, sir, I don’t think it’s a supply problem. I think it’s a greed problem.” At this, he smiled, then walked out leaving me to further explain what I meant by this to my students. So much for what I had come prepared to teach…
Last Spring, when oil was trading on the International market near $140 per barrel, I told my economics students that the only way to bring down the price of gas at the pump would be for Americans to reduce our demand for the product – drive less, buy smaller more fuel-efficient cars, etc. Most economists were saying the same thing, and Americans did just that. Demand today is way down now. In its weekly inventory report, the Energy Department’s Energy Information Administration said that gasoline demand fell by 6.4 million barrels to 202.8 million barrels for the week that ended August 8th. This is nearly three times more than the 2.2 million barrel drop that analysts had expected. In response to this drop in demand, oil companies have cut way back on production, shutting down refineries. And who can blame them? Why should they produce something in amounts that exceed the quantity demanded?
But, if Big Oil acted fairly and responsibly, and market forces worked like they are suppose to, not even considering the above mentioned decline in demand, gasoline prices should be lower. With oil’s price down from a high of $147 in July to less than $100 in mid-September, a 32 percent decrease, gas prices should have dropped by the same amount — right? So, let’s see… the national average price for regular unleaded in July was near $4.00. Today it’s something like $3.55. Therefore, the price of regular unleaded has dropped just 11 percent. Hmmm… perhaps our decline in demand actually worked to consumers’ disadvantage. Accordingly, I told my students that, even though I teach this stuff, I’m very much like Thomas Carlyle’s parrot. I just think I’m an economist. And that’s why economics is called, the dismal science. We do a pretty good job of explaining what’s already happened, but we’re not so good at predicting the future.
Another student asked, “How are they able to control supply so easily, Mr. Garry?”
In response, I reminded my class about our lessons on demand and supply elasticity, which is a measure of how responsive demand and supply are to changes in price levels. Demand for gasoline is very “inelastic,” or less susceptible to price changes. This is because we depend on it, there are no adequate substitutes for it, we can’t delay our purchases of it (when our tanks are dry we’ve got to buy), and it takes up a considerable amount of our disposable incomes. The elasticity of supply for gasoline, on the other hand, is very elastic. This is because producers, with the excess refining capacity they have today, can respond quite rapidly to market forces. When the price they have to pay for crude increases, they pay whatever they must, then just pass the additional cost on down-stream where the consumer ultimately makes up the difference. When demand for their product falls, they close refineries and lay-off employees so as to protect profits and take care of their shareholders. To do otherwise, they would be giving money away, and for-profit corporations hate to give money away.
This situation is illustrated in the demand/supply graph for gasoline at the right (hypo- thetical), wherein the demand curve (in blue), representing all possible prices and corresponding quantities demanded at each price, is relatively steep and down-sloping. This shows an indirect relationship between price and quantity, the Law of Demand (the lower the price the more people are willing and able to buy). But responsiveness to changes in price, either up or down, is small. On the other hand, the supply curve (in red), representing all possible prices and corresponding quantities supplied at each price, is relatively shallow and up-sloping. This shows a direct relationship between price and quantity on the supply side, the Law of Supply (the higher the price, the more producers would normally be willing to supply). But, unlike in the case of demand, respon- siveness to price changes for the supply of gasoline is relatively large, which means it is elastic, at least in the short-run. Notwithstanding, because oil companies can and, in my opionion, do act in collusion, they are able to rapidly adjust to market forces and control market supply. Therefore, prices can be controlled. In the example illustrated, demand and supply have both declined; the demand and supply curves both shifting to the left in equal amounts. Markets both before and after the shifts are at equilibrium where demand and supply curves intersect. So now one can readily see that, had the price of oil not declined in recent months (ceteris paribus), we could actually be paying more per gallon for gasoline as a result of our reduced demand for it.
So, my student was right to ask her question. Congress has asked the major oil companies’ CEOs the same thing over and over again in recent years. The answer they always get from industry leaders, however, is this: “We don’t set gasoline prices, the market does.” But the market isn’t operating today on a level playing field, and Congress knows it isn’t. It’s slanted in Big Oil’s favor, and it’s government’s fault, in the name of FREE trade, for having allowed the oil industry to organize itself so efficiently. This is why Big Oil is able to generate the huge profits we’ve been hearing about lately, profits that are at the expense of every other aspect of our economy. They have done this through a series of many mergers over the years, mergers that administrations, both Republican and Democrat, have allowed even though Treasury Department economic analysts have advised against it. Why? Well, I don’t know, I just think I’m an economist. But, as a free thinker, I’m pretty sure the answer can be found at the end of the money trail.
It is time for change — the right kind of change — change that we can believe in, which does not, in my opinion, include giving Big Oil more freedom to control prices and drag down the rest of our economy. Tax breaks for Big Oil will not lead to greater supply and lowering prices for consumers. Tax breaks for Big Oil will simply lead to higher profits for Big Oil.
I invite your comments, both pro and con.