Friday, September 23, 2005

Economics 102

The price of crude oil is going down, but gas prices are going up. Some intelligent people (like FH) are beginning to wonder if there's price gouging involved. Congratulations to these people, who evidently have passed Economics 101. While we should always be on the regulatory lookout for price gouging, there's a better explanation (I think), but it involves understanding Economics 102. I am not an economist, but I know enough about how my own supply chain works to think myself qualified to pontificate on the subject. Here is how I explained it to FH.

First of all, cars don't burn oil, they burn gasoline. Gasoline is made from oil at refineries. When refinery capacity is taken offline, as it is with the hurricanes, then you have two problems. The first problem is that there is not as much gas being produced. The second is that there's not as much oil being used.

The first problem, decreased supply of gas, leads to increased gas prices, because (as we learn in Econ 101) rare things cost more so long as people still want to buy them. The second problem is what to do with the oil that isn't being used at the refineries in Texas and Louisiana. It will have to be sent elsewhere and sold to people who otherwise might not have bought it. In order to do that, the price will lower.

And that's why the price of oil is going down even as the price of gasoline goes up. If this happened when there was no loss of refinery capacity and no other problems in the supply chain (like a trucker's strike or something), and the price changes were dramatic (as opposed to a 1-cent change in the price of a barrel of oil), I'd be suspecting price gouging too.

Another thing to remember is that the relationship between disabled refinery capacity and gas prices is not a linear relationship. You might think that if we lose 10% of our refinery capacity that gas prices should go up by 10%. Well, take that to its logical extension: if we lose 100% of our refinery capacity, and can no longer produce any gasoline at all, then prices should only go up by 100%, i.e. they'd double and never get any higher (that is, unless you're one of the 8 out of 5 people who thinks we can lose 120% of our refinery capacity). Clearly, that's not how the market works-- Stradivarius is 100% dead, but his violins keep going up in value anyway; they didn't stop going up in value when they reached double the price they went for during his lifetime.