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Are Higher Prices a Blessing?

Mises Daily: Tuesday, May 03, 2005 by

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OILPRICE_10yrsMitchell Anderson's article, "End of cheap oil is a blessing," attacks the widespread outrage over the unusually high gas prices of recent months. Anderson mixes three parts economic fallacy with two parts condemnation of government absurdities, and adds a dash of fervent environmentalism. The result is a hilarious (or infuriating, depending on your mood) case that we should all be pleased by higher prices at the pump.

The comedy ensues almost immediately, as Anderson opens with the following:

Enraged about the high price of gas? A trip to the corner store might provide a much-needed reality check to the indignation over excessive fuel costs. Have a quick look at what you can buy for a dollar a litre.

Milk? Nope. Bottled water? Not likely. Roofing tar? No way. For all the shrill outrage about rising prices, gas remains by far the most outrageously underpriced commodity in the world.

Now here are some strange arguments indeed. People apparently are not supposed to fret that gas is relatively more expensive, because in an absolute sense, it is still cheaper than other commodities. I would like to come up with an analogy to show why this is such a silly argument, but I think I'll just state that this is a really silly argument. (Okay, I can't help myself:  Suppose someone is appalled when he examines his itemized hospital bill after a routine procedure, because he has been charged $30 for two aspirin. I would not want to be the one to say to him, "Hey, don't sweat it! There's not too much you can get for $30 during a hospital stay.")

In any event, what is Anderson's point? The reason people are so concerned about the unit price of gasoline is that they have to buy so many units of it. My wife and I live in a fairly isolated area, such that we have to drive an hour just to reach the nearest Sam's Club. I can assure you that we don't drink two gallons of milk on the way. (And I can't remember the last time I went to the corner store to pick up some roofing tar.)

Sarcastic jokes aside, I am puzzled as to how Anderson can confidently state that gasoline is "the most outrageously underpriced commodity in the world."  There is really no other "correct" price for a good than the actual market price, so long as the government does not interfere. Now to the extent that some participants in a market have erroneous expectations about future conditions, we may expect that the market price in the future will change (once those expectations are seen to be faulty).

For example, if a nuclear bomb goes off next year in the Middle East and greatly restricts oil production, this will cause a huge spike in oil prices (after it happens). If people could only predict this catastrophe now, then current oil prices would be bid up in anticipation. Thus it is entirely possible that current oil prices are "too low," in the sense that people will regret that they sold at such a low price once the nuclear bomb goes off.

But even in this contrived example, no outsider can legitimately criticize the price negotiated voluntarily between buyers and sellers of oil. If someone like Anderson really thinks that oil is underpriced—and if by this term he means in the economically relevant sense that I have described in these last two paragraphs—then I invite him to invest his money in oil and thereby personally profit from his superior vision. (If he feels guilty benefiting from the foolishness of the rest of us, he can donate the gains to charity or endow an award for the best electric car design.)

This is an important point, so let me elaborate. If someone believes that the general consensus on the spot price of oil next year is overly optimistic, then that person stands to reap huge profits in the oil market. One obvious way to gain is to purchase oil now at the (relatively) low price, wait twelve months for the environmental or other conditions to become apparent to even the skeptics, and then sell the stockpiled oil at the higher price. (The price would have to be sufficiently higher to cover the costs of storage as well as foregone interest on the invested capital.) 

This activity will not only translate into a gain for the speculator, but will also do exactly what the environmentalist wants:  By buying oil now in order to sell it in the future (after prices have risen), the speculator increases the "low" current price and reduces the "high" price in the future. Oil has been shifted from a time period of relative plenty to one of relative scarcity, and the higher current price will encourage people to carpool, buy more fuel efficient cars, etc. Notice too that the magnitude of the speculative gain corresponds to the degree of error (on the part of everyone else in the market) that the speculator is correcting with his superior foresight.

Incidentally, the establishment of futures markets greatly facilitates a speculator's ability to act on his or her unique knowledge and hence effect these beneficial changes. In the story above, the speculator might be quite confident that the market's estimate of the future price of oil (in twelve months, say) is too low. But if the speculator knows very little about buying and storing thousands of barrels of oil, he or she may be unwilling to act on this belief.

With a futures market in oil, however, no such physical stockpiling is necessary. The speculator can earn a profit not by buying actual oil in the present and holding it for one year, but instead can buy oil futures for a relatively low price, and then sell them as the contract date nears and their price rises faster than everyone else had anticipated. The beneficial effects (in terms of reducing the current consumption of oil and so on) will still occur, but the actual job of stockpiling current oil[1] will fall on those with the comparative advantage in this task.

Let us return to Anderson:

Consider the long journey that a litre of gas makes from faraway oil fields to your local filling station. Oil deposits must first be found — often on the other side of the world or on the bottom of the ocean.

After massive infrastructure is developed, oil is extracted, transported across the globe, refined, and trucked thousands of kilometres to where you live. Let's not forget the massive military expenditures from countries like the U.S. to secure foreign oil supplies and the political and human turmoil that this creates. Considering all that, why then should gas cost about half as much as bottled water?

If people all of a sudden had started complaining about gas prices even though they were only rising with the rate of inflation, then Anderson's arguments about the life cycle of a liter of gas might make some sense. But since people are furious at how expensive gas has become in the last year or so, his story is rather pointless:  Is the technique of producing gasoline new?  Isn't that how they made gasoline twenty years ago? 

The amazing thing about Anderson's claims is that he seems to be suggesting that the executives at oil companies (of all people!) aren't charging enough to cover their costs of production. Now actually, this is where Anderson makes a valid point, for he says:  "Last year, Ottawa shovelled $5.9 billion of your tax dollars to the fossil-fuel industry. This is far larger than current government support for sustainable energy technologies that will no doubt become the cornerstone of our future economy."

Of course, Anderson believes that it is the government's job to steer the economy in the proper direction—we can't trust ignorant consumers and entrepreneurs to do that!  But he does have a point, that we might also coherently say that a commodity is "underpriced" if the government heavily subsidizes its production. However, even here the problem is not (as Anderson seems to think) that it is objectively wrong to use so much oil, and thus subsidizing the oil industry is also wrong. Rather, it is wrong to subsidize any industry, because this will only distort the profit-and-loss mechanism of the free market, which (left alone) will coordinate the plans of producers with the preferences of consumers. In other words, it would be just as wrong to subsidize electric cars as it is to subsidize oil companies.

Having given this modest tip of the hat to Anderson, I must conclude that even in his own worldview, he does not have the courage of his convictions. For it turns out that Anderson is not so aghast at subsidies for the use of fossil fuels after all:

Rather than posing for photo ops with the car industry, the federal government should seize the opportunity to make some long overdue policy changes. These include shifting gasoline tax revenue to public transit, increasing green infrastructure investment in cities, and expanding investment in renewable energy — the fastest growing energy sector in the world. … Some, like our beleaguered farmers, should be insulated from ballooning fuel costs.

Apparently, Anderson knows that SUV-loving soccer moms need to get their priorities in line, but no such wake-up call is necessary for the poor farmers. (I'm not familiar with the situation in Canada, but in the US farmers are no stranger to government handouts either.)  I wonder how Anderson would evaluate a proposal to give the homeless gas-guzzling RVs?

In conclusion, although Mitchell Anderson rightly excoriates government subsidies for fossil fuel companies, he doesn't understand why such subsidies are bad. In general, he completely neglects the operation of a freely floating price system, which is the only institution that can responsibly (and voluntarily) handle the problem of nonrenewable resources.



 

Robert Murphy is an adjunct scholar of the Mises Institute. He teaches economics at Hillsdale College. See the Murphy Archive. Buy his book on the stateless society. Discuss this article on the blog.

[1] Actually, what would probably happen in this instance is not that others (ignorant of what is driving the speculator) would store barrels of oil. Rather, the spike in the price of oil futures (caused by the speculator's buying) would induce the owners of oil fields to slow the rate of extraction. This is a much more efficient response, since (from a macro point of view) it is silly to pump oil out of the ground only to put it in a barrel in a warehouse for twelve months, waiting for the price to rise.