Supply/Demand and Profits: The Case of Oil

The most fundamental thing we all understand about economics without taking a course, the law of supply and demand, is flawed and incomplete. We intuitively feel that increased demand bids up prices, which then brings on new supply. Other things being equal, this works reasonably well. Other things are almost never equal.

Let’s take oil and gasoline as an example.

Gasoline prices may be rising, but if crude oil prices are rising faster than gasoline prices no new supply will come onto the market.  OilPumpSmallIt is even possible that supply may be reduced because crude prices rise so rapidly that refining and distribution costs are not covered, resulting in losses for gasoline producers. So, in order for rising prices of gasoline to bring on a rising supply, producers must be showing a profit.

This is not good enough. Hefty profits alone are not sufficient to bring on rising supply or increased competition. Wal Mart makes huge profits, but we do not see competitors flooding into the market to compete with them. The reason is that Wal Mart works on razor thin profit margins.

If prices are rising while profit margins are declining it is unlikely that new supply will be forthcoming. Therefore, new supply may be expected only when rising prices signals entrepreneurs to take a look, and rising profit margins induce them to wade in. In fact, there are plenty of examples where increased supply keeps coming even in the face of declining prices such as in the computer industry today. The higher the profit margins the greater the flood of new supply. I call this The Reiss Rule of Obscene Profit Margins: Relatively high and rising profit margins (not rising prices) result in increased supply.

Profit margin analysis is old hat to financial professionals, but apparently alien territory for economists. As proof I cite the windfall profits tax enacted under the Carter administration and recently re-proposed by certain policy analysts when oil prices were soaring. On the other side of the ledger I cite the special tax breaks enacted early in W’s administration when oil was in the $25 range. If you had any clue about what you just read, then it would have been obvious that we did exactly the wrong thing in each case.

When oil soared and profit margins rose for oil production in the 70’s the market signals screamed for more supply. By enacting a new “windfall profits” tax on producers plus a raft of onerous and costly regulations we did more than punish success. The windfall profits tax had a devastating effect on production because it led to sharply shrinking profit margins and severely dampened the market’s signals to potential investment by new oil producing entrepreneurs. This only exacerbated the problem.

Dollar sign 50

This is just one example of how those with the hubris to believe they know better than everyone else how the markets should behave actually do things that distort market signals and make things worse. Prices, profits and losses are the market mechanisms that transmit the information necessary for producers and consumers to make decisions that most efficiently allocate available resources. All the smartest guys in the room armed with all the computers in the universe can do no better.

Parenthetically, if one must interfere with the market when oil prices are high, then it follows that measures taken should increase incentives to produce more oil, not less. Therefore, reducing taxes on oil producers would be a better policy response to high oil prices than the typical, politically motivated, knee jerk reaction for higher taxes.


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