Econ 101
More and more recently, I get the feeling that our national conversation on the economic crisis would be so much better served, if the journalists take an introductory Economics class. For example, just a few nights ago, “60 Minutes” ran a program on Oil Prices. In its typical folksy fashion, it excoriated speculators for driving up oil prices in 2008. According to the program, “prices seemed to disconnect from the basic fundamentals of supply and demand.” Such dramatic gyration of prices in such a short period of time easily suggests manipulation. The program’s designated culprit: “Wall Street Speculation.”
However, something fundamental seems to be missing in this diagnosis. If profits were the motives of the speculators, and it was only speculators who drove up the prices, then how do they make money when there is no real demand to buy the oil from these speculators at such artificially high prices? After all, if 60% to 70% of the oil futures contracts are held by speculators as “60 Minutes” explained, then they would most likely lose money as there are not enough real buyers to take these contracts off their hands.
Well, let us see if Economics 101 can help here. Oil production, at least in the short term, cannot vary a lot. There are only so many wells operating at the same time, so much pumping and refinery capacity, and so many dedicated transportation routes. This is what economists call an “inelastic supply.” At the same time, the demand is also relatively inelastic. No matter how high the price is, people still need to get to work and school everyday. Electricity and heating consumption cannot be reduced quickly. The consequence is that if there is a slight change in the demand or supply curve, the price will change dramatically while the amount of oil transacted does not change a lot[1]. Do we have such a change in global demand for oil? Of course - the rapidly industrializing
Now, I am not suggesting there was no speculation. Surely, a speculative bubble developed as the price uptick picked up momentum. However, were it not for the real demand hop, speculator would not have jumped into the market. If speculators can make money so easily by creating false demand all by themselves, they would have done that a long time ago. It is the increase in real demand coupled with the quick price increases from inelastic supply that attracted the speculators into the market. Similarly, as the global recession dragged down demand, oil price dropped even more quickly than it went up. There were quite a few such “oil speculators” caught in this mayhem, including Boone Pickens.
Are there other instances of Econ 101 at play in our daily life? Yes, there are plenty. As I eluded to in prior blogs, the mortgage moratorium will surely entice moral hazard. In fact, moral hazard was prevalent during the mortgage boom. When banks gave mortgage brokers the right to lend on their behalf with zero percent down payments, they took advantage of it and underwrote as many loans as they could, mostly to borrowers with no means to repay it. As a matter of fact, with such great deals on the table, borrowers themselves sought out these “affordability mortgages,” even without help of the brokers. They clearly understood that they had an option on the bank. If the housing price goes up, they get all the upside, but when the housing price goes down, they could simply walk away and let the bank take the loss. The only surprise in this is why the banks were surprised that these loans turned out bad[1]. Mortgage brokers also illustrate other classical Econ 101 issues, including the agency problem and information cost. As I explained in a prior blogs, because of the high cost of analyzing what actually happened and the poor alignment of interest through compensation schemes, the agents have been taking advantage of the principals who outsourced their investing decisions. The results have been disastrous.
Another common Econ 101 phenomenon is called “externality”, that is, the total cost and benefit of an economic activity extends beyond what accrues directly to the actors in that activity. This is more common in our society than typically acknowledged. The use of carbon energy is externality in action. The gas price paid by a car driver only covers the costs of oil extraction, refining and transportation. However, the true cost to human society goes far beyond what is included in the $2 per gallon price. There is the reliance on the Middle-East and
Probably the most important lesson I learned in my Econ 101 class is that individuals’ happiness[1] is maximized[2] only when individual actors are rational, fully informed, with no externalities, and allowed to make decisions for themselves and bear the full consequences - in other words, under completely unrealistic idealized conditions. Two of the largest sectors of the economy are glaringly not under such conditions – (a) the government and (b) the healthcare sector. In the case of the government, every state, every sector of business and consumers use lobby to impact government allocation of wealth to their advantage – through taxes, government expenditures and welfare systems. Voters do not seem to care if the national deficit will cause tremendous inflation and burden future generations, because an individual is much better off when a government spending benefits him specifically while its costs are spread out over many. In the case of the healthcare industry, a third party payer regime, confused moralistic precepts, combined with the difficulty for patients to evaluate the actual “quality of care”, have led to massive inefficiency and waste. In either case, the result is bad policy and bad collective decision making. We cannot cover these two extremely complex issues in any more detail here. Suffice it to say that neither seems to be working very well at the moment.
Mainstream media is littered with sensational stories that ignore basic economic realities. I guess one can say it is natural as journalists need catch viewers’ attention. This is unfortunate as much of the public discourse on the economy is confused and distorted by idealogical platitudes. Viewers would be much better served to learn some basic economics for themselves. I hope I have shown here that you don’t need to know a lot beyond Econ 101 to understand much of what is actually going on. A little understanding indeed can go a long way in this case.
[1] Economists actually use a much less sexy name: “utility.”
[2] This maximization is qualified as well in that it just means you cannot increase one’s utility without decreasing someone else’s utility, which goes by the name Pareto Efficiency.
[1] Adverse selection is also at play here.
[1] In a demand supply graph, this is shown as sharply vertical supply and demand curves.
[2] In the long run, both supply and demand can respond to price changes. New exploration will be funded, more drills and refinery will be built and transportation capacity will be allocated. Also, substitute products (alternative energy) will be coming to the market to expand the supply of energy. On the demand side, consumers will use less energy, sell their gas guzzling cars and buy more energy efficient appliances.
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