One of my favorite quotes comes from the late (great) Austrian school economist Murray Rothbard-it is taped to my office door.
?It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.?
This quote has never been more suitable than to the current pontificating about oil company profits. Today, congress-in classic demagoguery mode–will hold hearings to discover whether these profits have been ?excessive.? (As an aside we are looking at an annual average profit margin of less than 8 percent.) The real ?state of ignorance? here is revealed in the lack of understanding of prices and profits and the relationship between the two. The entire field of microeconomics is devoted to the study of these topics. There are also dozens of books written by very famous, even Nobel prize winning, economists-Milton Friedman and Paul Samuelson just to name two-on these subjects. Yet, daily we hear ?loud and vociferous? pontificating on these subjects by both national and local commentators who have clearly not spent five minutes actually studying the relevant science. Next they will be handing out advise on how to treat cancer.
The Locker Room does not have enough space to clear up all of the hideously stupid remarks that are coming from our radios and tvs. But there is a consistent undercurrent to the mental void that is driving most of this chatter, namely that large oil company profits are proof that gasoline prices have been too high; that oil companies have been ?price gouging.?
Microeconomic principle of the day-while market prices may be a determinate of profits, the reverse is not true. Prices are set in the market by supply and demand. Profits are a by-product of this price setting process. In a market with no price controls, prices of any product, including gasoline and oil, will always move toward the level that insures that there are no shortages or surpluses-where the quantity supplied equals the quantity demanded. Profits are revealed after this process takes place. If this ?equilibrium market price? is above cost, profits will be earned-if they are well above cost there will be large profits. On the other hand, if these prices are only slightly above or possibly below cost, then profits will be low or even negative, there will be losses. Indeed there have been periods where the oil industry has suffered greatly-recently, the mid 1980s and the late 1990s-exactly because of this relationship between prices and profits. The point here is that prices have been what they should be and consequently, profits are what they should be. The analysis and conclusion would be the same if oil companies were taking losses. If prices are determined properly, through the interaction of supply and demand and not by government, then profits, whatever they are, are also being determined properly.
For the most part there have not been shortages of gasoline and oil, even when refining capacity was down by as much as 40 percent in the Gulf of Mexico. To the extent that there have been shortages, prices have been too low. If oil and gasoline companies had artificially lowered their prices to adjust their profits downward (ignoring their fiduciary responsibility to their shareholders) they would have been pushing prices below market clearing levels, creating gasoline shortages and the usual social unrest that goes with them.
Do I expect the Bill O’Reilly’s of the world, both nationally and locally, to understand this?-No. But luckily, the Jerry Agars of the world will.
