More on expensive gasoline

In my article about climate change, I mentioned in passing that "anybody who thinks the current price of gasoline has anything to do with 'peak oil' does not understand economics." Now, to be fair, some people really don't understand economics, which I guess is actually to be expected if you haven't studied it.

But you really can't understand gas prices without it, so here we go with some ECON101.

Introduction to price optimization, without even using calculus

Let's say I'm a widget vendor in 1999, and my company is the only company able to make widgets. (Because of a monopoly, patents, whatever.) I'm selling widgets to you for $0.50 each, and people buy 1000 widgets this year. Now let's say, as an experiment, that I raise the price a bit each year, so that by 2007, widgets are $1 each, and because of the increased prices, people are now only willing to buy 750 widgets a year. Quiz time:

1. How much money did I make in 1999 vs. 2007?

2. Did I do the right thing by raising the price?

3. What does this say about the trends in worldwide widget production?

Answers:

1. $500 in 1999 and $750 in 2007 (or $625 in inflation-adjusted 1999 dollars).

2. Absolutely. You made more money, but wasted fewer worldwide resources and did less work, which means you could get away with hiring fewer people and therefore ditch some unproductive middle managers. If you hadn't had a monopoly, or people hadn't needed widgets so badly (less price elasticity), you might have been in more trouble.

3. As the only producer of widgets in the world, I will have reduced my production rate because I'm selling fewer widgets and I don't want to fill warehouses with extras - that costs me money. This doesn't mean the world is running out of widgets, it means I'm smart enough to cut the supply of widgets because I make more money that way.

And back to oil

Now replace "widgets" with "1L of gasoline in Canada" in the above example, and you have the story of the worldwide oil market.

The only difference is... did people really reduce their gasoline consumption to 75% of its initial value just because the price per litre doubled? Actually no, I just made that up. Here's what it actually looks like (the red line is U.S. oil consumption; the green (or is it black?) line is irrelevant for our purposes, but click the image if you're interested):

(It doesn't matter whether we graph supply or consumption; they'll be about the same, because as with widgets, nobody wants to keep around warehouses with billions of barrels of oil.)

Wouldn't you love to run a business where consumption goes up even though you doubled the price? Okay, actually, as wlach points out, consumption (production) has actually been flat for the last couple of years, suggesting that maybe prices are high enough now.

But just as a thought experiment, imagine that gas prices doubled one more time. Would you drive less than half as much as you do right now? Really? If not, it's in their best interests to do it all over again. And you'd surely see the production actually go into decline as they make more money while you buy less gas.

Oh yes, the world is running out of oil, all right. But that has nothing to do with its price.