14 July 2008

Econ 110: Why Gas is $4 a Gallon

My favorite class in college was Dr. Kearl's Econ 110 class. Hands down. Cliche as it may sound, this was the one class that really changed the way I view the world. The first lesson of the class was that economics is not the study of money, but of choices. (Money is just a handy way of evaluating options on a standard scale.) Soon after that came the supply-demand curve, which looks something like this:

This is really a brilliant piece of work. The x- and y-axes represent quantity and price, respectively. The blue line represents supply, and shows that as the price people will pay for something increases, so does the quantity produced. The red lines represent two different levels of demand for a product (oil for example), which gradually decrease as the price increases. The supply and demand curves intersect at the exact price and quantity which maximize benefit for both parties.

Now I chose this particular graph because it exactly demonstrates why gasoline costs so much right now. Demand for oil is increasing, as represented by the demand curve shifting to the right. You'll notice that the point of intersection between supply and demand is at a higher price and quantity. Voila, there are your gas price increases.

With India and China fast becoming industrial giants, the demand for oil has risen dramatically. I read a statistic last week that the number of drivers in China is set to explode over the next decade, something like 8 times as many as they have currently. Oil being a scarce resource, and barring any practical replacement for the combustion engine (and anyone who invents this is going to be richer than Gates, Buffet, and the Waltons put together), the demand for oil is not going to drop anytime soon.

So we have two options for lowering oil prices: decrease demand through "eco-friendly" technologies that use less oil-- shifting the demand curve back to the left, or increase supply of oil or alternate sources of energy such as coal, wind, solar, or NUCLEAR power (we already have the technology; let's use it for heaven's sake!)-- shifting the supply curve to the right and effectively dropping the price of oil.

Coincidentally, the U.S. went through this same deal back in the 70's, when people could only buy gas on certain days based on the last digit of their license plate, and still waited in line for hours. Double-pane windows were invented then. Just a side note.

Both candidates spoke out on their energy policy Thursday. Obama's main thrust is on lowering demand, with increasing supply as a secondary strategy. McCain's plan primarily calls for increased supply. Here are the links. Inform yourself on what is quickly becoming one of the main planks of this year's election:

McCain's Energy Plan

Obama's Energy Plan


the narrator said...

one problem is that the demand for oil hasn't actually changed all that much. the supply/demand has barely changed relative to the rise in gas prices. rather the rise in oil has sharply increased because of speculation of a future change in oil demands.

i think we shouldn't change move to alternative energy sources in order to drop oil prices, but rather we should do so in order to make oil (and other buried carbon-based fuels) a thing of the past. this would greatly change our relationship in the middle east, strongly reduce the terrorist threat (would limit funding and not give them reasons to hate us), and would help defend us from the climate-crisis we are approaching - unless of course you are one of those who disagrees with 90% of the scientific community that believes it is because of human activity (or the other ten percent who believe it might be because of human activity).

rob said...

I remember seeing an ad for a toyota Hydrogen engine (yes still combustion) in the WSJ last fall. The detailed article was somewhat enlightening was it explained that the technology like hydrogen-powered cars exists but the infra-structure to back a consumer base does not. Similar to electric cars of the 90's where power-stations were not readily available, hydrogen powered cars can not succeed until some kind of mass movement is made to create an infrastructure that will support refueling stations. That constitutes a MAJOR financial investment. Has anyone heard of pilot cities with these cars?

On another note, interesting point to summarize the candidates platforms in such basic economic terms.

Mr. Andrews said...

I had a friend who was studying to be a bio-mechanical engineer-- his dream was to make cars that were powered by giant lab-grown muscles that ran on sugar water. No joke.

(As a side note, I wonder if any great inventors ever went to school in order to invent something. It seems like they largely work outside the system, synthesizing different fields and ignoring "common knowledge". Entrepreneurs too. Of course, this could just be an overly- romanticized perception of mine.)

If I were president, I would start the wholesale manufacture of Deloreans from Back to the Future, the ones that can fly and run on trash. They probably emit happiness, rather than carbons, too.

Loyd, to your comment: I agree that we need to move into other sources of energy, or dramatically increase the potency of oil energy, because I don't think we'll ever see cheap oil again. I personally favor nuclear power (and coal because it's cheap). People are afraid of these forms of energy though, because when they think of them they think of antiquated technology (1950s for nuclear, 1890s for coal). Perception is reality, though, so we have been stuck with oil as our main source of energy for decades. Case in point, there hasn't been a new nuclear power plant planned since the 70s.

the narrator said...

i'm much more supportive of nuclear energy (if the waste is recycled). i don't like the idea of coal because of the carbon.

Bryant said...

The biggest problem I see with your analysis of oil prices is that price can only reach that equilibrium if the market doesn't have barriers to keep it from doing so, and that isn't true of the oil market. Not only do we fail to adjust for negative externalities of oil use, but the primary supplier of oil is a giant international cartel that is free to set its own price, independent of what the market forces would dictate.

I'm not an economist and so maybe I don't know what I'm talking about, but with the little that I learned in Econ 110 the whole supply & demand curve doesn't really work in this example. (Kelly would probably use all eight of her hands to tell you what other possibilities there are and why there isn't any real answer or explanation.)

Mr. Andrews said...

B, I see your point about barriers against equilibrium, but I don't see those as being unique to the oil industry. I actually do believe that oil is in equilibrium right now. We buy as much oil as we're willing to at the current price, which is pretty much as much as oil suppliers are willing to or capable of producing. Sure, we'd like the price to be lower, but not enough to change our consumption. If we did change our consumption patterns, the cost of oil would drop. But we can't fool the invisible hand.

Maybe the real problem is that there is not enough oil to go around- that we've reached peak oil production- and so oil companies can charge as much as they want because demand keeps rising. In that case, the only thing we can do is look for alternatives, either by using less oil or more alternate sources.

If there is more oil out there, however, what we need is more competition in the oil industry- more companies to swoop in on those huge profits. I think that's probably the case, otherwise there wouldn't be the big brouhaha over domestic drilling. We, as a nation, probably own a lot of oil fields. (We actually import only half of our oil, and a huge chunk of that comes from Canada and Mexico. Only 20% of our oil comes from Middle East countries.) The real question becomes: Are we more willing to sell our oil-rich land to private companies in exchange for cheaper gas or to change our consumption patterns?

(I think that the question of the negative externalities of the oil industry is definitely a valid one, but this comment was long enough as is. In any case, factoring that in would make gas more expensive, but more reflective of its true costs.)

Bryant said...

The invisible hand doesn't need to be "fooled" if it's not allowed to operate.

I'm not saying that we shouldn't adjust our consumption, just that your analysis of demand isn't well-founded.

A supplier not being "willing" to increase their production does not indicate that we're operating at equilibrium. If we were in a competitive market other suppliers could come in and fill the gap and overall supply will still increase, but in the case of a monopoly limiting production is one of the ways that a company can be anti-competitive.

I'm not convinced that our demand is increasing. It seems like the current cultural trends are definitely towards a decrease in consumption, both based on general dissatisfaction with the price and on the climate crisis. In any case, decreasing our demand won't necessarily bring about lower prices because it's not a competitive market, so it doesn't really work to conclude that our demand hasn't decreased just because price has increased.

Mr. Andrews said...

Sorry, B- One problem with blogging is that it doesn't leave a whole lot of room for the clarification that you would get in a normal dialogue. I think we are arguing past one another, rather than with each other.

Looking back, your comment makes perfect sense if you consider the oil industry to have barriers to entry- which it certainly does (self-imposed, perhaps). A monopoly? I'm not convinced, but I agree that any anti-competitive activity should be stringently punished.

I think you're right that domestic demand for gas is on a downward trend, but the rising demand in industrializing China and India will offset that in the world oil market.

The UnMighty said...

Wait a minute, supply, demand, and cost are all somehow related? You just blew my mind.

bryant RICHARD casteel said...

Hey, sorry that this comment is a billion years out of date now, but Kelly showed me a post that reminded me of this discussion, so I wanted to share it.

This post by John Fleck (who apparently writes for some journal that I know nothing about) uses some statistic from the EIA to show that domestic consumption did fall and that the more recent drop in gas prices are a result.

I guess this shows two things: (1) that our domestic consumption really did decrease and (2) that the market must be more competitive than I was giving it credit for, since prices have also decreased.