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November 30, 2005

The Economics of Profits

In a NY Times story about the booming economy (with caveats) is this bit of information. There's a buried lesson here if you can find it.

By most measures, the economy appears to be doing just fine. No, scratch that, it appears to be booming.

But as always with the United States economy, it is not quite that simple.

Consumer confidence is bouncing back from what was arguably some of its worst readings in years. Gasoline prices-the national average is now $2.15, according to the Energy Information Administration- have fallen because higher prices tamped down demand and supplies in the Gulf Coast have been slowly restored. The latest read on home sales, released today, contradicts virtually every other recent measure of housing activity that generally indicate a slowdown. And yes, manufacturers' fortunes are on the mend, but few besides airplane makers are celebrating.

Let's look at one sentence in particular. "Gasoline prices...have fallen because higher prices tamped down demand and supplies in the Gulf Coast have been slowly restored.

During the period of high gas prices we had here, demand dropped. No surprise there. While that was happening, the pipelines had a chance to ramp up again and prices have dropped again. Supply and demand. No big deal.

But now we're hearing about punishing oil companies for making more money when the prices went up, even Republicans who have historically been against "windfall" profits taxes or price controls. There are so many things wrong with this.

1. Yes, the oil companies made more money in absolute dollars during the high price times, but then every business makes more money in absolute dollars when the prices go up. If you charge a 10% markup on a $5 item, the price is $5.50 and make 50 cents. If you charge a 10% markup on a $7 item, the price is $7.70 and you make 70 cents. Same profit percentage but more absolute dollars. By the way, is a 10% markup a reasonable profit? If so, you'll love the oil companies. Their profits are in the 7-10% range.

2. What happened when the prices went up? "Higher prices tamped down demand" which means more conservation took place. Isn't that what everyone would like to see happen more often? Instead, folks are trying to punish oil companies by suggesting either price controls or "windfall" profit taxes. The latter are really just retroactive price controls; they come with the threat that if you raise your prices by more than we think you should, you'll get nailed for it. But just as higher prices encouraged conservation, artificially lower prices would reduce conservation. Now that the prices have fallen quite a bit, it's almost a guarantee that gas usage has risen. If you want more conservation, don't punish companies for responding to supply pressures, because you're working against your own goals.

3. Let's assume price controls had been in effect during the Katrina aftermath; what would that have done to the gas situation? Demand would not have slackened off. As it was, with demand reduced, some gas stations still ran out of gas. Imagine what would have happened if demand just kept its usual pace. We would have had a far more serious gas crisis than just a few stations out of regular unleaded. It was the higher prices that actually kept the inconvenience from becoming a panic.

So the "solution" to this "problem" is to tax 7-10% profits as "windfalls", discourage conservation, and make the crisis worse next time around. Your government at work.

Posted by Doug at November 30, 2005 01:53 PM

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» Econ 101 and “windfall” oil company profits from The Unalienable Right
Here’s a good post from Doug at Stones Cry Out about the “excess profits” being generated by the evil capitalist pigs of “Big Oil” and the calls by even some supposedly free-market-friendly Republicans to pitch free marke... [Read More]

Tracked on December 1, 2005 12:49 PM