One of my favorite quotes came from economist Professor Murray Rothbard:
“It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.”
Rothbard’s words are particularly suitable to recent pontificating about oil company profits. Congress is conducting hearings to investigate whether the profits are “excessive.” As an aside, the 12-month average profit margin for oil companies is below the national average for all industries.
At the heart of this “state of ignorance” is a poor understanding of prices and their relationship to profits. The field of microeconomics is devoted to the study of these subjects and there are scores of textbooks by economists as ideologically diverse as Milton Friedman and Paul Samuelson, where one could go to lift himself out of this state of ignorance. Indeed, in economics this analysis is no more a question of ideology than is an understanding of how the heart interacts with the lungs. Yet, daily we hear expressed “loud and vociferous opinions” on these subjects by national and local commentators who have not spent five minutes actually studying the relevant science. Next, I expect these same folks to be giving advice on how to treat cancer.
There is not enough space here to clear up all of the economic misconceptions that are coming from politicians and radio and TV commentators. But there is a consistent undercurrent to the mental void that is driving most of this chatter, namely that large oil-company profits are proof that gasoline prices have been too high; that oil companies have been “price gouging.”
Microeconomic principle of the day—while market prices are a determinate of profits, the reverse is not true. Prices are set in the market by supply and demand. Profits are a by-product of this process. In a market with no price controls, prices of any product, including gasoline and oil, will move toward the level that ensures no shortages or surpluses, that is, where the quantity supplied equals the quantity demanded. Profits are revealed after this process takes place. If this “equilibrium price” is above cost, profits will be earned—if it is well above cost there will be large profits. If these prices are only slightly above or possibly below cost, then profits will be low or even negative, there will be losses. There have been periods where the oil industry has suffered greatly—recently, the mid 1980s and the late 1990s—exactly because of this relationship between prices and profits. The point is that prices have been what they should be and consequently, profits are what they should be.
This analysis would be the same whether oil companies were losing money. If prices are determined by the interaction of supply and demand and not by government, then profits (or losses), whatever they are, are being determined properly.
The term “shortage” refers to a situation where people cannot get all of the product they desire at the going price. For the most part there haven’t been shortages of gasoline. Even when Gulf of Mexico refining capacity was down by as much as 40 percent, there were few situations where limits were placed on how much gasoline people could purchase.
Higher prices in recent weeks have played an important social function. They encouraged people to economize on driving and to consume less gasoline. If oil and gasoline companies had succumbed to social pressures and had artificially lowered their prices to adjust their profits downward (ignoring their fiduciary responsibility to shareholders) they would have been pushing prices below market clearing levels. At lower prices people would have economized less on their driving, creating gasoline shortages with queues and limits on purchases. This could only be appealing to those who think that Richard Nixon and Jimmy Carter were good presidents.
Roy Cordato, Ph.D., is an economist and vice president of research at the John Locke Foundation.