Stories At The Margin
columnist: Christopher Espinal

Topic: Energy
The Economics of our Current Oil Situation

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Will Oil Prices Drop?

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by Christopher Espinal
(Conservative)
Sunday, June 15, 2008

Oil is becoming increasingly problematic for all production dependants on its energy. As inflation soars and prices continue to rise, while wages remain stagnant, this is having an income effect on consumption. This is especially evident for those individuals who drive and appreciate air conditioning.

What's causing this increase in the oil price?

Firstly, we must understand that the value of the dollar has been declining lately as the Fed printed excessive amounts of money to stimulate the economy. Because additional dollars in circulation failed push out aggregate demand, as suggested in Keynesian theory, inflation has gone out of control - sort of like the 1970's. Keep in mind though, that our case is rather different since the Fed has given signals that it will reverse its recent role in the market to preside over controlling inflation.

Another interesting reason could be that OPEC has begun its activities of collusion again, as they have during the 70's. They are able to cooperate to set prices and act as a monopoly. Most economists may disagree with this idea since cooperation amongst profit seeking firms can be very difficult.

The Fed and collusion concept aren't the only explanations at hand. One can certainly argue that oil companies are beginning to plan for a new political season of tax increases on "greedy private firms" and renegotiations of trade agreements. If this is the case then the oil market is sending signals that it expects Democratic Candidate Barack Obama to win.

These large changes in oil prices have only caused Obama to spew more of the same rhetoric.

So what if he was to actually place a tax on private oil, as has been suggested? It's very expensive to build new plants and rigs for increasing supply in the short run so the supply is fixed. Thus, the supply curve is perfectly inelastic showing that the tax would fall entirely on the producer. However, in the long run, expect some of that tax to get reallocated to the consumer since quantity supplied becomes more responsive to price.

If our goal is to reduce costs, taxing suppliers "to teach those greedy companies" may not be a great idea since consumers will eventually see a price increase. However, if the government is trying to get companies to think about creating substitutes, then this may be a great incentive.

There is something that many politicians tend to ignore. If oil companies are going to be taxed by the United States, then these companies will look for consumers that demand smaller tariffs: China and India. This free-rider problem will defeat the purpose of our initiatives.

Obviously, taxation on this good will result in many problems and debates. Hopefully, responsible politicians will play a role in determining policy.

As far as responsible politicians are concerned, can they do anything to increase the supply of oil in efforts to drop prices? I think not!

If we understand oil companies as having significant market power in their sector, acting as oligopolistic competition, then they will not seek to increase supply on the basis of efficiently allocating oil to consumers. In other words, they don't supply at market equilibrium. They supply at a point where their marginal cost is equal to their marginal benefit. In this case, marginal cost is different from the ordinary supply curve of a perfectly competitive market. This means that Bush made a worthless move in trying to convince King Abdullah of Saudi Arabia to increase their supply of oil.

All in all, with potential taxation, a lot of friction with free trade agreements, and a sector with very little competition, don't expect prices to drop unless collusion fails or wages adjust to rising inflation - induced costs.

Interesting Rebuttals:

According to this article ([link edited for length]), the Saudi Arabian Oil suppliers will shift their supply with fears of upcoming political impositions such as higher taxes and the demon of price controls. This graph shows that the Saudi oil producers are increasing production by 300,000 barrels a day. It seems in their best interest, for future expectations, to create the smallest political brawl for their consumers.

Another interesting explanation for this phenomenon would be that people care about fairness. Why do you think that the NFL never sells its super bowl tickets at market price?! It would probably be bad for future business.

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2008 Christopher Espinal, all rights reserved.
Published: Sunday, June 15, 2008
Last modified: Monday, June 16, 2008

The views expressed in this article are those of Christopher Espinal only and do not represent the views of Nolan Chart, LLC or its affiliates. Christopher Espinal is solely responsible for the contents of this article and is not an employee or otherwise affiliated with Nolan Chart, LLC in his/her role as a columnist.

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