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Big Bad Oil

Memorial Day is approaching, and with it the summer driving season and a drowning torrent of seething articles about the greedy rapaciousness of oil companies gouging us for gasoline.

Petroleum has become the Jew of commodities, irrationally hated and scapegoated. All manner of insult and ire and conspiracy are directed at it and its producers. Environmentalists say that it's destroying the planet. (It's not.) Politicians whip up populist frenzy against "windfall" profits. (Oil companies aren't especially profitable.)

But it's the conspiracy theorists that really burn me up. You know, they're the ones who are so eager to believe that gasoline prices are "manipulated" and cannot! possibly! be due to seasonal factors such as higher summer consumption and the mandated change of blends. They further believe that refineries are the best-run industrial facilities in the world, requiring no maintenance and never having unexpected problems. Sharply increasing demand from China and political instability in oil-producing nations are similarly dismissed as minor factors.

There is a vast array of mostly ignored but straightforward and true reasons contributing to the rise in gasoline prices. There's also a common and plausible but false one: that because the gasoline price is inelastic, oil companies will withhold supplies in order to increase their profits.

No, they won't. Really. I mean it.

Companies do not face the alternative of (A) sell all the gasoline they can produce or (B) withhold some production and sell the reduced output at a higher price.

Alternative (B) does not exist except for a legally protected monopoly.

The actual alternative for most products, including gasoline, is: (C) withhold some production and sell your reduced output at the same price as (A). This obviously results in lower revenues for (C) than (A), which is why the refineries in fact choose (A).

Where does (C) come from? From the fact that the additional quantity of gasoline in question is, by itself, profitable to produce. Even if a large supplier would like to raise the price of each unit sold by restricting the amount they offer for sale (because the price increase on a large quantity of sales would more than offset the lost additional sales), a smaller supplier would see this as an opportunity to expand production into the void left by their larger competitor. Compared to the larger company, a greater fraction of the smaller company's revenues would be due to the additional sales volume, so they would be less willing to withhold production in order to support prices. And to a would-be upstart competitor, the additional volume would represent 100% of their revenue, so they would have no interest in all in withholding production. The smaller the company, the more profitable it would be to expand production in response to another company's cutbacks. This incentive is strongest for new entrants; it would create a breeding ground for competitors.

The crucial point here is that if the marginal unit of gasoline can be produced for a profit, then it will be produced. As a supplier your only decision is whether you will produce it yourself or whether you will cede market share to your competitors.

Your choice is between (A) and (C) — option (B) is an illusion. So you choose (A).


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