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Profits and High Prices: More Economic Nonsense

November 14, 2005

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Anyone with even a basic understanding of economics should have seen it coming: our leaders are threatening oil companies for making money off higher prices. In the aftermath of hurricanes Katrina and Rita, gasoline prices shot up, as large chunks of US refining and transportation operations were shut down or severely curtailed. In the wake of higher prices, which already had politicians riled, oil company profits are up.

Not surprisingly, Congress has jumped on the latest earnings reports with its typical anti-capitalist stance, with Senate Majority Leader Bill Frist (R-Tennessee) demanding that oil executives appear before the Senate to explain their good fortune. As has been reported in the news, members of Congress are already introducing legislation "to outlaw oil price profiteering."

Although I believe that most members of Congress, not to mention most people who live in or near Washington, DC, are incapable of understanding even basic economic concepts, nonetheless I think it worthwhile to present a small primer on prices and profits. While I wrote a similar piece last year, the concepts are worth retelling.

Before addressing the current situation with oil and gasoline markets, however, I must present an overall explanation of what profits are and why they exist. Since most people seem to believe that profits themselves are illegitimate — or at least look askance at "windfalls" — I begin with that particular subject.

Karl Marx held that profits represented an "unjust expropriation" of income from labor, which had the legitimate claim to all income produced by production. (Thus, under socialism, since "labor" would "own" all of the means of production, by definition, all income had to go to labor, and, thus, no "exploitation" would occur.) Although few people, outside the liberal arts academic community in US universities, would call themselves "Marxists" today, the mentality of Marxism continues to exist, and we see it full-blown on Capitol Hill in this latest escapade.

While we tend to see profit as existing only in the business realm, in reality it is a part of all of our lives. If one measures profit as the value of an action versus its opportunity costs, then one can expand the concept of profit to many things that we do. For example, I can see my income as a form of personal profit, some of which comes from a small "windfall" of becoming a faculty member at a college seeking business school accreditation (and having journal publications to boot, which placed me at an advantage with others who applied for this job).

Any time one engages in activity in which the perceived benefits outweigh the perceived costs, one enjoys a form of profit (or what Murray Rothbard called "psychic profit"). If profits that come about via business activity are illegitimate, then Rothbard's "psychic profit" also would have to fall into that category.

As for the "legitimacy" of profit, one needs to ask whether or not all parties in the process of producing and selling the goods in question were paid according to previous agreements and whether or not coercion was involved. If all of the activities were voluntary, all the way to the purchase of the final goods, then it is difficult to criticize the existence of a profit that came about through production and sale of said goods.

For the most part, people do not understand what profits are or how they come about. As Rothbard pointed out, in an "evenly rotating economy" where all parties involved in the transactions of producing and selling goods had access to all the relevant information and always acted correctly on that information, there would be no profits — or "economic" profits, which are profits over and above their opportunity costs.

Furthermore, Rothbard wrote that profits occur because of "temporarily" under-priced factors of production. That is, the owners of the factors involved in production and sale of the good did not foresee the higher price they could have received for their particular factor and settled for a lower price, instead.

Take the current oil situation, for example. For many years, oil companies have been performing at a low end of profitability, as the market value of petroleum products has been relatively low. In fact, from the early 1980s until well into this decade, profits for oil companies lagged behind profits in other industries.

Contracts that were made with employees and suppliers reflected that low profitability, and oil firms also based their planned projects on low prices continuing indefinitely. When very real supply problems caused by hurricanes made fuel prices spike, oil companies were in the position of paying prices for many of their factors of production based upon anticipation of fuel prices that were much lower than what the markets currently command. Given that situation, it should come as no surprise that oil profits that reflect that period are high.

What people in Congress and elsewhere do not realize, however, is that this state of oil profitability is only temporary. At least one of the following two things will occur, and it is more likely that we shall see a combination of activities. First, many of the owners of the factors involved in producing fuels, seeing oil company profitability, will re-negotiate their own agreements when it becomes feasible to do so. Second, it is doubtful that the highest prices can stay aloft for very long, and when they fall, so will the oil companies' profit margins.

According to the current political rhetoric, the high prices are related to high profits, as though oil company executives suddenly thought of a new strategy to increase profitability: raise prices. If oil firms could control their profit margins with such an approach, then one wonders why they would have waited until after Katrina and Rita to do so. If they simply were myopic, then it would seem that a sharp attorney long ago would have pulled together a class action shareholder suit to sue oil companies for dereliction of duty.

While the surface rhetoric from the two main political parties seems to go in different directions, neither Republicans nor Democrats are being helpful. Democrats call for price controls or new taxes on oil company profits, both of which are downright destructive. Republicans, on the other hand, are demanding that oil companies "reinvest" their profits in new refineries, more exploration, and the like.

While the Republican "suggestions" might just seem to be good business advice, in reality it is almost as harmful as the "solutions" called for by Democrats. Oil firms will invest in those things Republicans want if and only if they perceive future profits to be made from them. However, oil executives have been badly burned before and must make investment decisions based upon the realities of the markets, not political oratory.

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For example, right after oil prices were decontrolled in 1981, oil companies chose to invest profits in new exploration, synthetic fuels, and the like, in the belief that oil prices would continue to rise. Instead, as we now know, oil prices went south and many of those same oil firms found themselves facing real crises as their original investments soured.

It would be a foolish malinvestment of resources for oil companies to invest in new refining capacity if the future prices of fuels were to fall. Now, I would not mind seeing more capacity, given that a new refinery has not been built in the USA since the presidential administration of Gerald R. Ford. However, if the long-term structure of market prices within that industry cannot support the kind of investment that Republicans are demanding, we then would see a waste of resources if executives made investment decisions under the political gun.

Moreover, if oil executives decided to make long-term investments in additional capacity just to head off draconian controls being demanded by congress, then we would be witnessing what would be, in effect, government control of a vital industry. The bills would come due later but, rest assured, they would come.


William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him MAIL. See his Mises.org Articles Archive. Comment on the blog.


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