The Commissar notes this exchange with Tim Russert and Samuel Bodman (the Secretary of Energy):
MR. RUSSERT: Mr. Secretary, if, if demand is up but supply is down, why are the profits so high?
MR. BODMAN: For that reason.
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MR. BODMAN: You know?
MR. RUSSERT: Play it out.
MR. BODMAN: Demand is up.
MR. RUSSERT: Correct.
MR. BODMAN: Right?
MR. RUSSERT: Right.
MR. BODMAN: So you’ve got more demand, you’re going to force price up.
You’ve got, you’ve got limited supply, and you’re going to have…
The Commissar says,
Someone draw him a picture.
Okay, no problem, here it is…well two actually. The first shows what happens when demand increases,
Note that demand shifted from D1 to D2. As a result the price increases. How does a firm react in a competitive market? Well here is that picture as well,
Note that as the price goes up from P1 to P2, due to the shift in demand, the firm expands production up to the point where (Short Run Marginal Cost) SMC = Price. The gray area represents the economic profits (profits over and above normal profits) that the firm would enjoy. In short, increasing profits when demand rises is precisely what we’d expect to see. This is elementary economics, not some sort of fancy schmancy cutting edge theory.
Now, in the case of an industry that is not competitive the pictures are different, but the basic logic is quite similar. Basically what happens is that a shift in demand to the right sends a signal to firms that marginal revenue is increasing. Marginal revenue is that revenue on the last unit produced. Given that the firm was initially in a position where marginal cost (the cost of the last unit produced) was equal to the old marginal revenue, the higher marginal revenue (due to the increased demand) says that production should increase. This would have the effect of bringing the two (marginal cost and marginal revenue) back into alignment. Since in the short run entry by compeititors is not possible, the firm enjoys economic profits.
However, those economic profits are what would entice entry (speaking in general terms). Thus, economic profits are important. Without them, there would be now entry. What happens to price once entry occurs depends on the cost structure of the industry in question over the long run. If costs are constant in the long run, then the price will eventually come back down. If the costs are increasing then the price will decline, but not to its previous level. And if costs are decreasing then the long run outcome is a lower price than the initial price. However, if we “take away” the economic profits then you get no entry.
If there is a problem with entry into a given market my first advice would be to look to the political situation. Either the government and/or voters have made entry into that market difficult. There are some “natural” barriers to entry such as large sunk costs, but I’m not sure that actually is the case with the oil industry. Large fixed costs could act as a barrier and that could be a problem in the oil industry, but when you have these kinds of dollars in profits, I think entry would tend to occur. Hence the likely culprit is the political situation.
MR. RUSSERT: But that’s a decision by the oil companies.
MR. BODMAN: No, it is not. That is a decision—those are—oil is traded every minute of every day, and it’s traded basically 24-by-seven. And it’s, it is determined in marketplaces in New York and London and Tokyo, all over the world. That’s the, the—the oil companies do not determine the price of oil; the producers determine the price of oil.
MR. RUSSERT: They determine, they determine, help determine the price at the pump. And if the, if their profits are going up, they have made a decision to add on the cost at the pump at such a level to guarantee higher profits.
Seems pretty clear that Mr. Russert got an F in elemantary economics.
