Arnold Kling  

Oil: Marginal vs. Average Cost

Outsourcing... Free-Market Health Care?...

The Washington Post's Steven Pearlstein needs to learn the difference between marginal cost and average cost.

Without some miracle breakthrough like controlled fusion, energy independence is unattainable, probably undesirable and discussion of it avoids the real question of why the world continues to let the price of a crucial commodity be set at artificially high levels by a notorious cartel.

Ironically, at this moment of $54-a-barrel oil, OPEC is no longer in control. Given the current realities of supply and demand -- and the panic and speculation driving oil traders -- it is the market that is setting prices...

The entire article is like that. On the one hand, he concedes that oil prices are determined in a market. On the other hand, he makes it sound as if the reason that prices are high is that OPEC and the oil companies have suddenly gotten greedier.

My assessment is that demand has increased, and some supplies have been disrupted. As a result, the cost of satisfying the last increment of demand, the marginal cost, is now over $50 a barrel. The marginal oil comes from low-yield wells or wells that produce high-sulfur oil that is costly to refine. That makes the marginal cost high.

Average cost of oil production remains low. That is, there is a lot of oil that can be pumped and refined inexpensively--but not enough such oil to satisfy demand. Owners of low-cost oil, like any suppliers in any market, can charge marginal cost and earn high profits.

With more oil exploration and drilling, oil companies could reduce the pressure on supply. They have an incentive to do this to the extent that they believe that prices will remain high. However, if they believe that prices are going to fall again, then they would lose money by investing in capacity.

I think we will see some new capacity come on stream. It seems to me that even if prices slip back in the short run, the overall trend in the oil market is for demand to increase, and for occasional supply disruptions to lead to price run-ups. So I would think that investments in new production capacity would be profitable.

See also the online discussion forum on Pearlstein's article.

UPDATE: See also Jerry Taylor and Peter VanDoren, who write

the best remedy for high gasoline prices is...high gasoline prices, which provide all the incentives necessary for motorists to conserve, for oil companies to put more product into the marketplace, and for investors to look into alternatives fuel technologies.

For Discussion. Should we go back to a system of oil price controls in order to reduce the profits of greedy suppliers?

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TRACKBACKS (6 to date)
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The author at Tex the Pontificator in a related article titled Should We Return to Oil Price Controls? writes:
    Arnold Kling critiques an article in the Washington Post and explains the difference between average and marginal cost. To generate dialog, he posits the question whether we should "go back to a system of oil price controls in order to reduce the profi... [Tracked on October 14, 2004 9:55 AM]
The author at Division of Labour in a related article titled Nonsense on Stilts writes:
    More media ignorance. Arnold Kling sorts out the mess emanating from the Washington Post's Steven Pearlstein.... [Tracked on October 15, 2004 1:30 PM]
COMMENTS (22 to date)
Joshua Allen writes:

Would it be possible to institute price controls at this point, given the increasing demand from China and India?

Bob writes:

Why don't we just impose our price controls on China and India too? Or forbid them from consuming any oil? Or, as we are violating basic laws of how the world works so we might as well throw aside thermodynamics too, just start costlessly changing salt water into light crude. The process has been available for decades but the greedy oil companies have supressed it. And a byproduct of this magical transformation process is a compound that is perfectly safe and causes people to become thinner and better looking. But it's being supressed by the fashion industry. And Microsoft.

I enjoy the site Arnold and appreciate the time you put into it, but price controls? Can we really get someone to argue the other side for something that is so obviously immoral and economically idiotic? Not that I doubt those people exist, but anyone browsing your site must have an open enough mind to recognize the blazingly obvious.

Lawrance George Lux writes:

We should revert to Price controls to limit the demand for Oil, thereby reducing the Trade Deficit. Greedy Profiteer suppliers needs not enter into the discussion, except to spell "Relief" for American taxpayers (remembering I am in favor of major increases in Business taxes as well). lgl

Bob writes:

lgl takes the challenge! Are we talking about the same price controls (ie, ceilings)? To reduce demand you would have to set an artificially high floor, which usually isn't what people mean by price "controls" (think price "supports"). Controls increase demand but reduce supply, which does reduce consumption but in an extremely inefficient way. Not as bad as simply outlawing the use of oil, but on the same track.

William Woodruff writes:

Unfortunately, there is no easy solution. If there were, we would have one already.

However, if we want to decrease the (quantity demanded)use of this commodity, the method is simple, and has already been discussed ad nausem, on this board and many countless others.

Don Boudreaux writes:

Coming of age during the price-controlled and shortage-infested 1970s, I can say unequivocally that the only good achieved by price controls is that they provide unequaled classroom examples for use by economics professors -- examples of outcomes that are obviously undesirable.

Lawrance George Lux writes:

We are indeed talking about ceilings. I would suggest a Dollar per gallon over Market-set value. Transport can be exempted as necessary travel--like the military, though I would suggest Airlines not get the exemption. It would never pass, but would be very effective. Most SUVs currently burn two tanks a week, and probably be reduced to one tank per week. This is considerably less traffic, at 15mpg. lgl

Paul N writes:

Price controls? As soon as domestic producers start making oil from farm products and tar sands in short-sighted response to the current high prices, I bet you'll start seeing support for "price floors" to "protect fledgling industries" so that the US gets closer to "energy independence". They'll call in Lee Iacoca to testify before Congress that the government would be saving itself money by propping up the price of oil, since the alternative will be paying unemployment and welfare to all the US energy industry workers destined to be fired.

Steve writes:

"I would suggest a Dollar per gallon over Market-set value."

The problem is that this simply introduces a tax on the economy that would most severely impact working class people (at least outside the handful of centralized US cities w/ mass transit). The extra $80-100 a month per vehicle this tax would cost a working family would most likely drain a significant portion of their discresionary income. The main fallacy is that the tax does not acknowledge the largely static nature of short term energy demand. Work does not get any closer, most people cannot afford to replace their cars immediately etc. People just need to realize there are no short term fixes either on the demand or supply side. In the long run, improving the fuel effiency of the vehicle fleet needs to be done, but this will take 10-15 years to accomplish

Bob writes:

lgl, I am confused. A price ceiling/max *above* the market price would have no impact on the price at the pump, right? Beyond, of course, sending the signal that the Gov is willing to meddle. I can see your logic if you mean a price floor/min (which, I believe, most of us are interpreting as a gas tax).

shamus writes:

Why not just use ration coupons? It seems simpler than price controls, and it would have the same effect.

Brad Hutchings writes:

Dead and burried with Nixon a decade ago. There is absolutely no way either party could propose explicit price controls at any level without being called Girly Men. Much more likely that people could use the lgl logic above to demagogue SUV owners and legislate consumption limits. And even that isn't very likely. Politicians are smaller and more fragile than SUVs. OK, that was just a figurative statement, not a serious suggestion to run a meddling, regulating politican over.

p writes:

What is the problem we are tyring to solve? We have a temporary surge in oil prices ... why the panic? Arnold makes an execellent point on marginal and average costs. The wedge between the two prices will fall as speculators are accomodated. One route would be to sell oil reserves and flush the system. The only trick is to convince governments to act with a profit motive and their citizens best interests.

Austin writes:

I think the real problem is that OPEC keeps prices high by having "supply controls" instead of "price controls". When I say supply controls, I am referring to the fact that OPEC decides how many barrels of oil each country will produce.

I agree that we should NOT control prices. That would never work when there is a fixed supply.

Since the prices can't be controlled, the only solution is to increase supply. The only solution is to stop OPEC from ever again deciding upon the number of barrels of oil each country will produce.

Jim Erlandson writes:

With more oil exploration and drilling, oil companies could reduce the pressure on supply.

Like many things in economics, business and life, to drill or not to drill is not a simple question. Because the number of rigs is finite, the cost of drilling new wells goes up with the marginal prices of oil and gas. The dayrate (cost of leasing a drill rig for one day) is tracked by several services and reported to subscribers for a fee.

There is also good information available about the number of rigs in operation. This page has some interesting graphs showing the relationship between the number of active rigs and oil prices.

Joshua Allen writes:

Jim, those charts are really interesting; I have learned a lot from this thread. Austin, is there any evidence that OPEC actually is effective in keeping the prices high? The arguments have been made that OPEC is basically maxed out anyway, and any further increases in oil output are lower quality, higher cost, and it's unlikely that output can increase significantly at the same marginal cost anytime soon.

Mcwop writes:

Alex Tabarrok at Marginal Revolution has a post linking "price controls" to vaccine shortages.

Post Here

Personally, I am hard pressed to find situations where price controls in any form work very well.

Lawrance George Lux writes:

All here seem to think little of my projected Gas tax idea, but the numbers are in and Oil imports increased over 12% in August, and not just in Dollar increases. We really have to initiate something to curtail SUV roaming, just like Cellphones. lgl

Bernard Yomtov writes:

I think price controls are certainly a bad idea, and I suspect Arnold's question was posed tongue-in-cheek.

Still, the price of oil, while set in a market, is hardly set in the sort of competitive market that maximizes efficiency. There is a cartel and they do exert something similar to monopoly control, allowing for the usual inability of a cartel to have quite as much control as a true monopoly.

There are two issues here. The first is the purely economic one that in a monopoly market prices are set above marginal cost, leading to a deadweight loss. The second is political - much of the moey spent on oil goes to unattractive governments and surely some winds up supporting terrorism.

We can pretend these problems don't exist, but they do.

jackinnj writes:

the price of energy cracked within 3 weeks of President Reagan's liberation of natural gas prices in 1981 -- six years later the price of crude FOB New York Harbor (or Bayway refinery) was around $8/bbl --

the energy crisis of the 1970's was caused by price controls.

Kevin Carson writes:

Any time the government steps in to restrain the "greed" of one industry, it's really acting
on behalf of all the other industries that depend on it. It's interesting that all the large-scale antitrust actions in U.S. history involve infrastructures or resources that were central to the corporate economy as a whole. IOW, the very same industries that were nationalized under the European variant of state capitalism.

The state is executive committee of the state capitalists. When it intervenes to the detriment of some particular industry, it may use populist rhetoric to sell the policy to us suckers (with the help of court intellectuals like Art Schlesinger). But the real constituency it's serving is the rest of the corporate economy.

HS writes:

I was thinking about this today in relation to Congress opening up Alaska to drilling.

Does anybody know the difference in production cost of Alaskan Oil vs another standard cost benchmark?

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