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24.05.2004, 18:30

Profits Do Not Cause High [Oil-]Prices / Artikel mises.org

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Profits Do Not Cause High Prices
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William L. Anderson

[Posted May 24, 2004]

<img alt src="http://www.mises.org/images2/oil.gif" align="right" border="0" width="200" height="137">With
gasoline prices rising above $2 a gallon for unleaded regular, it was only a
matter of time before the politicians would start"connecting the dots"
as to why prices are where they are today, or at least why they believe the
current situation exists. In a recent pronouncement, John
Kerry's campaign declared that consumers are
being gouged because"oil companies are raking in record profits." In
other words, the high prices exist because oil companies are being profitable.

Such opinions hardly are new.
During the 1970s, oil companies were denounced on a near-daily basis, with
President Jimmy Carter claiming in 1977 that oil companies were"ripping
off" consumers, and that the best way to hold down oil prices was to hold
down oil company profits. Even when Carter wisely began to do away with the
government price and allocation controls that had strangled the system for
nearly a decade, he demanded a draconian"windfall profits tax" on
oil companies as a means to hold down oil prices.

(Indeed, to"fight"
against the inflation that plagued his presidential term, Carter's"inflation
czar" Alfred Kahn of Cornell University announced a"voluntary"
wage/price/profit plan. Firms that wished to do business with the government
first had to demonstrate their"anti-inflation" credentials by
raising prices and wages by six percent or less annually and by earning six
percent or less in profits. In other words, according to Kahn,
"high" business profits significantly contributed to inflation.)

To be fair, Kerry's campaign is
not blaming the gasoline price increases solely upon increased oil
company profits, but the fact that his spokesmen have included oil profits as
a culprit is cause for concern. The higher profits that oil companies now are
enjoying have not caused the high prices; instead, they are a temporary
manifestation of what has been occurring in the petroleum markets and are the
result of factors that for the most part are beyond the control of oil
executives.

Over the past few years, I have
written a number of articles on this page concerning oil and gasoline prices,
including a recent
piece dealing with the most recent price hikes.
The purpose of this article, however, is not to explain why oil prices are
increasing, but rather to point out why those increases are not being
caused by higher oil company profits. Furthermore, I explain why profits
cannot contribute to higher prices, period.

The first thing to remember is
that profits are residual income. That is, they are calculated after the
fact. Another way to put it is to say that because profits ultimately are
figured by subtracting total costs from total revenues during a given period,
one can know what profits might be only after costs and revenues have been
identified.

As a simple example, assume that
my children open a lemonade stand. After paying $5 for the ingredients, they
sell enough lemonade at the end of the day to make $15. Now, that does not
mean they have earned $10 in profits, since one assumes that the value of the
time the children spent there was not zero. (They could have engaged in other
activities that now are foregone because they chose to sit all day at their
lemonade stand.)

For now, we will assume that the
opportunity cost of their time is $5, which now gives them a residual of $5.
If, at the end of the day, the children decide that they would like to earn
more profits, they have two choices. They could (1) test the market to see if
tomorrow's customers will be willing to pay a higher price per glass (and
still purchase enough lemonade that would increase revenues—the"elasticity"
test, (2) find ways to cut their costs so there would be a larger cushion
between what they paid for the ingredients and what they gained in revenues.

The potential success of their
little business also would depend upon other factors, such as weather and
location. The former condition is something over which they have no control,
while their options for the latter also are somewhat limited.

Assume that they raise their
prices and, at the end of the day, their revenues are $20. Assuming the other
costs remain constant, their end-of-the day profit now is $15. Does this mean
(1) that the higher profits caused the higher prices, and (2) have they"gouged"
consumers of lemonade?

The answer to (1) obviously is no.
Higher revenues gained from the fact that they were able to raise prices but
not lose customers enabled them to earn higher profits for the day. As for
(2), the answer still is no. After all, the pejorative term"price
gouging" simply means raising prices in the face of increased demand for
a good, of a decreased supply of that good, or a combination of changes in
demand and the relative supply.

Taking the example further, assume
that when they purchase those ingredients, the weather is cool. However, a day
later when they open their lemonade stand, it is the hottest day of the year,
and people who ordinarily would not purchase lemonade now are lined up to buy.
Assuming that the supply holds out (a heroic assumption to be sure, but it
works for this example), they are going to have more revenues than normal even
if they had decided to keep prices where they were when the average revenues
were $15 a day. Again, profits are increased because of increased demand for
their product.

If the hot weather were to
continue for awhile—and the prices of ingredients stayed the same—then the
children could continue to earn higher profits. However, let us now assume
that the supplier of lemons and sugar, realizing that the hot weather has
increased demand for lemonade ingredients, now raises the prices for those
ingredients.

The typical response one might
receive from the"man on the street" (or a politician) would be this:
If the prices of lemonade ingredients increase, then the children will raise
lemonade prices and pass the increases through to consumers. However, such an
analysis is incorrect, even though government policies often are made with the
assumption that it is a truism.

The children could successfully
raise prices only if their customers would permit that to occur. With higher
prices surely would come fewer customers (unless the children originally were
charging less than what the customers were willing to pay). After all, the
youngsters can make lemonade and they can offer it for sale; they cannot force
people to buy it.

All this is fine, the reader might
say, but oil and lemonade are two different goods, so different rules apply.
The answer is a simple no. If both oil and lemonade are scarce goods—which
they are, prima facie—then they are subject to the same laws of
economics. After all, it is the universality of economic laws that enable
economists to assess a given situation and provide coherent answers.

Current oil markets are not
confounding the laws of economics. We have two things at work, the first being
demand for products that come from crude oil, and, second, issues of relative
supply both of the raw products and finished products like gasoline. As noted
in previous articles, U.S. politicians have worked overtime to place barriers
in front of those seeking to produce and sell goods made from petroleum—and
then are shocked, SHOCKED when prices of those goods are rising.

The current situation is not
difficult to explain. On the demand side, we have a recovering economy in the
USA (at least for the time being), as well as strong increased demand for
petroleum products in Asia, and especially China. Summer travel always
increases demand for gasoline, so even when supplies are static, prices for
gas usually go up during the summer months, and especially around the July 4
holiday.

To better explain the situation at
hand, however, Austrian economic theory is needed. First, as Carl Menger and
then others like Ludwig von Mises and Murray Rothbard pointed out in their own
works, the markets for final goods like gasoline also drive the markets for
goods of"higher order," such as petroleum, which derives its value
from the value of the goods of lower order that are produced from it. To put
it another way, gasoline prices are not increasing because crude oil is more
expensive. Such analysis, which was the hallmark of the so-called classical
economists, simply is wrong and wrongheaded.

Gasoline does not derive its
"value" from petroleum. Instead, petroleum is valuable because it
can be converted into products like gasoline, nylon, and heating oil. After
all, people had known about petroleum for thousands of years before someone
actually was able to make useful products from it. In past times, crude oil
usually was considered to be a nuisance, a condition that changed only when
people found ways to create products from it that people wished to buy.

Second, the accusations from the
Kerry campaign and other critics of the oil industry turn economic analysis on
its head. Higher prices do not arise because oil companies suddenly have
become profitable. If that were true, then how could one explain that over the
past two decades, oil
company profits have been lower than overall
average business profits?

As Rothbard writes in Man,
Economy, and State, economic profits exist because of temporarily
underpriced factors of production. In the case of oil companies, the economic
profits occur because they purchase crude oil at a price which is supported by
gasoline prices at, say $1.50 a gallon. However, increases in demand for
gasoline enable producers to charge higher prices for that product than were
originally anticipated, giving them a temporary profit. Of course, once crude
oil prices rise in response to the increased demand, then that small window of
profit is gone unless consumer demand brings up gasoline prices again.

To put it another way, the current
rise of profitability in the oil industry is temporary. At the same time, the
U.S. Government, through environmental and tax policies, is doing all it can
to make gasoline artificially scarce. As noted in a previous article, it has
been about 30 years since an oil refinery was built in this country.
Furthermore, environmental laws both encourage the importation of gasoline
into the USA, but also discourage foreign producers from making the products
that must comply with a crazy quilt of air quality regulations. That is
nothing less than a prescription for very limited supplies of gas, with
substantially higher prices becoming the norm.

Most people instinctively
understand that limited supplies of a product that is heavily in demand will
mean higher prices. What they do not readily understand is the chain of
causality, especially when business profits are involved. The Kerry camp—as
well as most members of the political classes—usually get it wrong. It is
the Austrians, not surprisingly, who best comprehend the particular dynamics
of the oil markets. Unfortunately, policymakers for the most part do not wish
to listen to the Austrians, which means, in the end, that consumers will pay
the price for the government's refusal to listen to simple, economic logic.

__________________________

William Anderson, an adjunct
scholar of the Mises Institute, teaches economics at Frostburg State
University. Send him MAIL.
See his Mises.org Articles
Archive.

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