Thursday, April 27, 2006

Bad syllogism 

Smartie misses an ECON 101 lesson. Trying to take down analyses by Mayor Doug and Pat Cleary, he correctly summarizes Pat's argument -- oil prices rise because of supply and demand forces beyond the control of oil companies and thus cannot be held accountable for massive profits (however defined) -- Smartie starts his attack with this logical statement:
If it were true that gas prices reflected the price of crude oil then oil company profits should remain relatively stable- just like those of most blue chip industries.
That would get marked wrong in my principles course. A change in the demand for crude oil, whether for use in heavy SUVs or just out of fear of future supply disruptions, will necessarily increase profits. Take this presentation as your instruction. Then assume demand shifts and ask, what happens to the size of the profits rectangle?
The fact that oil companies are reaping record profits as oil prices increase indicates that they are raising gas prices faster than can be accounted for by the price of oil alone.
The equilibrium price in an imperfect market like the oil refining business is going to be set by not just how much demand shifts but also by the cost of increasing output. That cost is very high right now because firms are still changing over from MTBE to ethanol blending, dropping inventories like a stone.

If you've got the last case of bottled water in a drought area, your profits on that will appear high. But that's only because you are counting current revenue against sunk costs. The relevant cost to the water seller is the cost of the next case. So too with gas -- the relevant price for economic profit (vs. accounting profit) is the opportunity cost of bringing it to market today.

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