Radley Balko has an article on the FOXNews site about politicians trying to look like they’re doing something about high gas prices. I agree with his basic premise, which is that high has prices are mostly the result of natural market forces and that any attempt to fiddle with them is likely to cause more harm than good. That’s sound economics.
An important exception arises if the oil companies are able to work together as a cartel to fix prices. It’s here that Balko makes a mistake:
People buy less of a good when it’s more expensive. When gas is expensive, for example, we cut back on driving. We walk, or take public transportation. Which means the oil companies sell less gas. If the oil companies are colluding to keep prices high, then, it’s to their own detriment.
That’s just wrong. To see why, let’s use some made-up numbers: Suppose gas is selling for $3 per gallon but only costs $2 per gallon to make, for a profit of $1 per gallon. If people buy a billion gallons a week, that’s a billion dollars in profit per week for the gasoline industry.
Now suppose all the companies get together and decide to raise their prices at the same time to $4/gallon and keep it there. If customers don’t change their buying habits, they’ll buy $4 billion worth of gasoline per week that only costs the companies $2 billion per week to make. The gasoline industry will double its profits to $2 billion per week.
Balko correctly realizes that won’t happen. Customers will adjust their buying habits and reduce the amount of gas they use, so oil companies won’t sell a billion gallons anymore. For example, people might reduce gas consumption by 10% to 900 million gallons per week, so oil company profits will only be $1.8 billion per week. In other words, if the oil companies raise prices, they will earn more per gallon but sell fewer gallons, so a doubling of per-gallon profit won’t double industry profits. However, the oil companies will still be making more profit than before the price increase.
In order for increased sales prices to actually hurt the oil companies as Balko says, sales volume would have to fall far enough to result in a lower profits despite the increased profit per gallon. With the numbers I’m using here, gasoline consumption would have to fall by more than half—to less than 500 million gallons per week—so sales are less than $2 billion and therefore profits are less than $1 billion.
The real world is obviously different from the numbers I’ve made up here, yet everyone who has studied the oil and gas markets agrees that consumers don’t respond much to increases in price. Clearly there must be some price at which demand will fall enough to reduce profits, but nobody believes we’re close to that now. For proof, we only need to look at how the prices increases of the past year have affected consumer demand for gas: The reduction in demand is barely detectable. And oil company profits are at an all time high.
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