The Big, Bad Oil Industry
Written by YellowJacket on March 3rd, 2008I also wrote this for International Political Economy, in response to another student’s post suggesting a litany of policies to make the market for oil “more fair.”‘
While I initially agreed with your post with regards to considering consumer interests more than demonizing oil companies, your post quickly turned down a road I don’t want to go down and some of your suggestions would actually turn out harming oil companies and consumers.
You are right that government price controls and special taxes would be a mistake because attempting to harm a company’s bottom line is only going to lead to the customer paying for it through a higher price.
While the U.S. does have huge oil reserves, it also has many sources of oil that environmental groups have pressured politicians in Washington to ignore. These include the portion of the Arctic Nation Wildlife Reserve that was set aside by Congress for oil exploration and would only have an ecological footprint the size of Dulles Airport! Also, the United States is not drilling offshore in many places (such as along Florida’s coast) that could also help increase oil supply while other countries have jumped at the opportunity to do the same thing not far from our shores (a Chinese company recently snagged some oil-rich waters, for example).
You are right that it is a problem of demand and not supply, but increasing supply to meet the increased demand could only help oil prices.
Your next argument, for Congress to rescind all existing tax breaks for the oil industry, would ironically enough also harm oil companies though you advocated a different approach in your first paragraph. Once again, attempting to hit the companies where it hurts (the wallet) will only be passed along to the consumer in the form of higher prices.
Then you go even further off the deep-end with increased government regulation of the industry with a call for a windfall profits tax. As much as people love to demonize the big bad oil companies for their “outrageous” profits, if you look at their profit margins they average about 8-10%, meaning for every dollar the company spends they get back 8-10 cents on that dollar. This is not an unreasonable profit margin and is lower than other industries; for example pharmaceutical companies have margins much higher, around 20%. And yet again, taxing “windfall” profits will only end up hurting the consumer in the end and will not serve to help the situation but to harm it.
The market for oil may not be fair with regards to the cartel of OPEC manipulating oil prices, but to suggest that we need more regulation on the domestic industry because it isn’t “free” or “fair” is counterproductive. Politicians would do well to decrease, rather than increase, government regulation of the industry so the market can be more free. A more free market benefits the consumer and allows for competition and innovative research.
3
PM
I’d give you an F for the economics in this little rant of yours. I don’t have time to go through the whole thing, but here’s one glaring and obvious error:
A profits tax has no effect on output or prices. Consider a tax of p percent on firm profit. Whatever output and price level maximizes profit also maximizes (1-p)*profit. Firms maximize profit. QED
Or are you enrolled in one of these colleges where you just draw pictures in economics and ramble about ideas because the “professor” is too stupid to set up the statement of the problem formally? This is exactly the problem that occurs when economics is taught “intuitively” rather than with calculus. Unless you’re really smart, your intuition leads to dead-wrong conclusions that become patently obvious if you’d bother to take 5 seconds to actually think about the problem in a precise way.
3
PM
I’ve taken Calc I, Calc II, Calc III, and Differential Equations at Georgia Tech, one of the most rigorous schools in the nation, but thanks.
I’m an Economics & International Affairs major, so my economic background is pretty thick, thanks for the concern though.
3
PM
Respond to my point, then. Is it not true that the maximizer of a function is the same as the maximizer of a monotonic transformation of that same function?
How can the output and price level that maximizes profit be different than the output and price level that maximizes (1-p)*profit?
3
PM
Publius, I think you need a new hobby beyond starting fights on blogs.
Those posts are interesting Langley, keep them coming!
4
AM
Am I wrong that the maximizer of profit is the same as the maximizer of (1-p)*profit?
I’m starting a fight by pointing out a basic fact? Commodore Perry’s claim is flat-out wrong in this case, a fact blatantly obvious to anyone who understands arithmetic.
5
PM
Actually, Publius, you are right, incomplete, and wrong.
In the simplest application of calculus, where Profit = Total Revenue – Total Cost you are right. Applying a multiplier of (1-r) to profit yields an identical result when taking the partial derivative of profit with respect to quantity produced:
Marginal Revenue – Marginal Cost = (1-r) Marginal revenue – (1-r)Marginal Cost = 0
Therefore, in order to maximize profits in both cases, you set quantity such that the marginal cost equals the marginal revenue as if there were not tax. This differs from the per unit tax, which provides an immediate shift to the supply curve.
However, taking the analysis out of the short run, partial equilibrium analysis and applying a more general approach, you will see that it still produces the same results as a per unit tax – once the firm can change its input mix.
Let’s begin by rearranging your initial equation (1-r)Profit = (1-r)(Total Revenue – Total Cost) to Read (1-r)Profit = (1-r) Total Revenue - (1-r)Total Cost = (1-r) Total Revenue - (1-r)Fixed Cost - (1-r) Variable Cost.
Your first implication from this transformation is that the company will no longer achieve its expected rate of profit from its capital investment. Since the NPV is based on an annuitized return that you have diminished by a factor of (1-r), the firm will reconsider capital outlays to replace depreciation.
In this case, the firm will face an altered equation for optimizing their mix of capital and labor. As can be seen in the third part of the equation, this applies to both the variable input (labor) and fixed input (capital). As a result, optimal firm size (design capacity) is determined by maximizing L = f (K,L) - l ((1-r)TC – rK – wL).
For simplicity, I will assume a homogeneous production function.
As a result, the rational choice for the firm is to reduce the design capacity of its plants – meaning less of both labor (unemployment, but it happens under both scenarios) and capital.
The reduction in capital yields an upward shift in the marginal cost curve assuming that the firm was and will be operating in Knightian Stage II – and since your tax does not distort the firm’s choices, they must be operating there. This shift in the marginal cost curve will be indistinguishable from the per unit tax.
Except for the possibility that it results in an increased reduction in capital in the industry over a per unit tax. But without accurate estimations of the firms’ production functions, you can’t answer that. Do you happen to have them handy, Publius?
Thus, while taxing profits produces no shift in the short run, it does behave in a similar manner as a per unit tax as soon as the firm can change its input mix. Therefore, you are incomplete.
But, let’s touch on something you missed altogether – the impact of taxing profits directly and solely on profits.
Everyone loves to paint corporations as the bad guy. They personalize the owners of the corporation with their high salaried agents – the executive board.
But, here is a fictional story I tell my students (oops, did I fail to mention I have a PhD in economics?) to illustrate the impact of frivolous lawsuits (similar to what you propose).
Suppose you pull up to McDonalds and order a cup of hot coffee from the drive through. Then, you foolishly place the cup of hot coffee between your thighs. Upon pulling out of the drive through, the action of working the peddles in your car causes you to spil the coffee and scald your thighs – OUCH!
Subsequently, you successfully sue McDonalds for not adequately warning you that their hot coffee might scald you if you spill it on yourself (ever wondered why the drive through at McDonalds has a sticker warning you about this? Now you know why).
As a result of your lawsuit (which is financially indistinguishable from your tax), McDonalds reduces its dividends by a few cents. This reduces the stock value by less than a dollar. No big deal, right? After all, the CEO makes millions, if not billions.
But, let’s take a real look at the major share holders of any corporation. Two of the largest independent (not management) shareholders of stock are insurance companies and banks.
In order to compensate themselves for the loss of value an revenue, the insurance companies must increase their rates – just like a tax. So far, we’ve merely shifted your tax from the consumers who use petroleum products to anyone with insurance.
Thanks! Now, you’re paying some of my gas tax for me!
But, let’s really get to the fun part. Reducing the dividends and price of the stock that makes up pension funds reduces their solvency. Three possibilities exist:
1) They increase the cost to current labor without increasing benefits to cover the loss – Great! Now a union member is paying my gas tax!
2) They reduce their payouts to their members. Now, somewhere, there’s a grandmother (maybe yours, maybe mine), who lives off of that tiny payment. And, she’s not doing well. Because her payment drops, she can’t afford her medicine (she makes too much for welfare) and her cold becomes pneumonia and she dies. Ouch, Publius, your incomplete analysis just killed Grandma!
3) They become insolvent and no longer provide any benefits. Hmmmm. I’m not to cool on that one. It’s worse than the previous one. Now, your policy kills lots of Grandmas.
At this point, your analysis has become plain wrong.
Listen to some sage advice – economics is about knowing where to apply the math, not just what math to apply.
If it seems too good to be true (no impact on production or social welfare as you imply), then it isn’t. You merely moved the welfare loss to other markets.
12
PM
The previous post contains several ambiguities that effectively become errors.
Your claim that a tax on profits has an impact on output and prices in the long run is based on an assumption that needs further clarification:
“The company will no longer achieve its expected rate of profit from its capital investment…the firm will reconsider capital outlays to replace depreciation.”
This is true only if the profits tax is sufficiently high that the rate of return from capital investment is lower than the return that the firm could have earned from alternative financial investments. As long as the tax is calibrated to still allow the firm an above-market rate of return on capital investment, a profits tax would have no effect on the level of capital investment. Thus, no effect on marginal cost, output, or prices — even in the long run.
Excess profits taxes are designed precisely to seize a proportion of returns that far exceed normal levels. Thus, a correctly calibrated tax on the level of profit would not create an incentive to disinvest from capital — or reduce plant size, as you put it. With no reduction in capital investment, the rest of your argument falls apart. Indeed, the profits tax continues to have no effect on output or prices.
The lawsuit part of your essay is discursive and off-topic. I’ll point out only that you apparently never bothered to inform yourself about the McDonalds lawsuit — if you had, you would have realized that the suit was perfectly legitimate, and in fact quite a poor exemplar of this so-called “junk lawsuit” crisis that you guys like to imagine actually exists. I suggest that you spend class time teaching economics instead of ranting about off-topic personal opinions.
12
PM
Pubes: Why, in the US, are there such things as “profits that far exceed normal levels” in your mind? What is normal, who decides what that is? Is it gross profit? margin?
I am assuming that the pet rock inventor would have been crushed by your system. He goes out, picks up rocks and sticks googly eyes on them and then sells them for a nearly infinite profit. This line of liberal thinking is nothing short of frightening. Even more so than Big Bad Dick Cheney!
12
PM
A “normal profit” is a level of profit that compensates a firm for the opportunity cost of its resources (i.e. the next-best use of its resources — mainly interest it could have earned on money tied up in capital).
An “excess profit” is a level of profit that exceeds a normal level — above the level that would be necessary to prevent the firm from switching its resources to another use.
Therefore, if the tax simply seizes a fraction of excess profit only, this will have no welfare effects in the short run or in the long run. By definition, if a firm earns ANY excess profit, it has no incentive to switch its resources to any other use. Seizing a fraction of this is simply a transfer of surplus from producers to consumers.
You can say that it’s unfair if you want (a normative judgement), but that there is no inefficiency (net welfare loss) is a positive statement.
13
AM
Ah, I see - so we should mandate what “level” of profit is allowable for our corporations to earn now?
I could further pick apart your argument but I don’t think it’s worth my time.
13
AM
Horrifying.
13
AM
The point is that you could pick apart my argument on NORMATIVE grounds. It’s perfectly valid to claim that such a seizure is unfair or kind of sad. This is all a question of value judgment. Where did I ever say that such a seizure should take place or that it was fair?
However, the statement that it induces inefficiency or that there is welfare loss passed on to consumers is factually incorrect. This is not a value judgment.
My previous post did not contain any value judgments. I defined normal versus excess profits (a tautological statement), and then went on to explain that a tax affecting only excess profits has no effect on firm behavior or consumer welfare. This is also a tautological statement.
I never said anything about what level of profit is allowable or fair. Nor did I claim that the government “should” engage in such seizures. In fact, I never expressed any opinions at all. Talk about projection — you evidently can’t understand what it means to consider an idea outside of the context of your own opinions.
13
AM
I’d like to see you explain to a businessman which parts of his profit are “normal” and which ones you deem “excessive,” and explain in all your economic prowess that taxing what you call his “excessive” profit won’t have any effect on his firm’s behavior.
Sometimes economics requires more than your rigid theory and taking into consideration leaving the classroom (shocking, I know) and actually seeing how businessmen and companies respond to economic conditions in the real world.
13
PM
The definition of “excess profit” is tautological — not a value judgement. It has nothing to do with what I deem to be “excessive”.
As I said repeatedly in my previous post, never have I advocated that such a tax actually be imposed. There are plenty of reasons to oppose it — Some people strongly value private property rights, for example.
All I ever did is to assert that such a tax need not affect output, prices or consumer welfare. This is a positive, tautological statement. You seem to have some block in your mind preventing you from considering an idea in the abstract. If you oppose something on principle, does this mean that you’re incapable of discussing its properties?
13
PM
Looks like you changed your reasoning from “it won’t affect” to it “need not affect output, prices or consumer welfare.” Gettin’ kinda wishy washy there, eh?
You had an extremely detailed and well explained response in economic terms to your liking that you dismissed out-of-hand (not without personal insults, of course) from someone I know who is far better than I at understanding and explaining the intricacies of every little economic step.
Maybe you should quit whining, calm down a bit, and get over yourself.
13
PM
I did not dismiss the result out of hand. I pointed out a key assumption on which the whole argument rested that the author tried to obfuscate his way around. Without the assumption, the genesis of his welfare loss disappears.
You then made a technical error by confusing “excess profit” (a positive, tautological definition) with “excessive profit” (a value judgment). As I said before, you apparently are unable to divorce yourself from your own opinions sufficiently to think about something in an analytical way.
I guess any time I demonstrate an error in your thought process, it’s “whining”.
Incidentally, I see at least two sources of welfare loss stemming from the profits tax, but nobody here has yet pointed out a single valid one.