A reader of my analysis of the backlash against the profits of big oil companies thinks that one of my statements is “laughable,” namely, my claim that the “oil companies, including Exxon Mobil, have been doing their utmost to increase the supply of oil, including reinvesting a major portion of their profits precisely for that purpose. But time and again, they have been prevented from increasing the supply of oil by the environmental movement and the maze of governmental regulations and prohibitions that it has inspired.” He writes:
Come on! Are we supposed to believe that the brave oil companies are the helpless victims of these environmental laws?! . . . government has supplied to oil companies a means of preventing supply from being increased when they raise their prices – in effect, a monopolistic privilege, in the Rothbardian sense… and we are to believe that oil companies are very angry about this and are trying to increase supplies in spite of it?! . . . Environmental laws are just some of the monopolistic privileges that oil companies enjoy, and it is laughable to suppose that they aren’t happy with that!
This reader simply ignores all of the repeated efforts of the oil companies to develop ANWR, to increase offshore drilling, to build new refineries and pipelines, and the fact that time and again they have been frustrated in these efforts by the environmental movement. He asserts the conspiratorial, leftist line, apparently endorsed by some prominent libertarians, that government intervention, indeed, socialism and communism, is a capitalist plot, that, if not invented, is at least promoted by big business and the rich for purposes of their further enrichment.
He is right, of course, to describe the environmental laws as monopoly legislation. They forcibly restrict the production of oil and thereby make its price higher. But their existence and result are not the responsibility of those who produce oil and thereby add to its supply and make its price lower.
I think that this reader and his mentors have probably been unduly influenced by the doctrine of “marginal revenue” and the supposed sensitivity of big business to a consideration of it, as opposed to a consideration of price, in deciding whether or not to expand production.
Marginal revenue is the change in total revenue that results from a change in production. It is believed that it follows from the concept of marginal revenue that the larger the share of an industry’s business that a firm accounts for, the less is its incentive to expand its production, because it will have to suffer the resulting reduction in price on its correspondingly larger, already existing output.
Thus, for example, if an industry presently produces an output of 100 units of product, which it sells for a price of $10 per unit, its total revenue is $1000. (I’ve kept the numbers as small and simple as possible.) If the industry’s output expanded to, say, 105 units, and the result was a fall in price to $9 per unit (a fall that is necessary in order to find buyers for the additional units), the total revenue of the industry at that point would be only $945, an actual reduction of $55. Its marginal revenue would thus be -$55. From the perspective of the marginal revenue doctrine, if there were only one firm in the industry, producing 100 percent of the industry’s output, its production would never expand in such circumstances, because the result would be lower earnings from the larger volume of production than from the smaller volume of production.
I want to point out that even in this, most extreme case, it does not actually follow that the industry’s output would not expand or even that the one firm that presently constitutes the industry would not expand its output. Everything depends on whether or not the production of the additional 5 units is profitable apart from its effect on the earnings from the existing 100 units of output. If, for example, the total cost of producing 5 units to be sold at $9 per unit is less than $45 by enough to provide a competitive rate of profit, those 5 units will be produced and the price will fall. The only question for the firm that presently produces 100 units is whether it wishes to produce 100 units at a price of $9 or 105 units at a price of $9. To whatever extent, it is possible for anyone else, anywhere in the world, to produce those additional 5 units, our firm simply does not have the option of choosing between 100 units at a price of $10 or 105 units at a price of $9. Its only choice is between 100 units at $9 or 105 units at $9.
In such circumstances, it’s not at all unreasonable to expect that even our 100 percent supplier firm would be out there attempting to increase its output. Because if it does not increase its output and anyone else does, it ends up with the same lower price, but does so with less volume than it might have had and accordingly earns lower profits than it could have earned.
Now the actual fact, of course, is that neither any individual American oil company nor all American oil companies taken together accounts for anything close to 100 percent of the world’s oil output. The United States consumes approximately 25 percent of the world’s oil output, and roughly half of that is now imported. This implies that total oil output in the United States itself is about 12½ percent of global output. The percentage of global output produced by any individual American oil company, such as Exxon Mobil or Chevron, within the United States is far less than that.
In terms of our example of price and quantity, the actual fact is that a large American oil company might presently produce on the order of 2, 3, 4, or 5 out of a global oil output of 100. For such a company to be able to increase its own output by an amount equal 1 to 5 percent of the present world oil output, the sheer percentage increase in its own volume would almost certainly substantially outweigh the percentage decline in the world price that its expansion caused. If, for example, Exxon Mobil could go from 5 to 10 in output, while the price declined from $10 to $9, its revenue would rise from $50 to $90, making it vastly more profitable.
The more the price of any commodity exceeds the cost of producing additional quantities of it, the more powerful becomes the incentive to expand its supply. This is as true of the price of oil today as of anything else at any other time. All that is required to bring the price of oil down is to get the government and the environmentalists out of the way. The American oil industry would then lead the charge in the expansion of production.
[For further discussion of the subject of monopoly in general and of the doctrine of marginal revenue in particular, see Chapter 10 of my Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). A pdf version is online at www.capitalism.net and at www.mises.org.]
This article is copyright © 2006, by George Reisman. Permission is hereby granted to reproduce and distribute it electronically and in print, other than as part of a book. (Email notification is requested.) All other rights reserved.
{ 8 comments }
The person you quote does have a point. The oil companies did enjoy some benefits from restricting further supply – by restricting new refineries and nuclear power plants. But this just goes to show that in seeking special interest policies can be self defeating later on.
A similar thing occured in the late 19th century with railroads. The railroad companies fully supported the forest preservation intellectuals in pursuit of restricting land ownership so that their previous land acquisitions can gain value. Later on this significantly hindered their own ability to build railroads through the protected regions.
Robert Higgs has some excellent stuff on this topic.
Another thing to note is that 1970′s environmentalist watermelons did not have weather model simulations for the next 50 years.
Environmentalism is a much more serious threat today than 30 yrs ago – probably something the oil companies did not predict.
Prof. Reiseman,
While you’re analysis here is valid, it is not true to say — as it seems like you’re saying — that big corporations never lobby for State Intervenionism. This is simply not true, it happens consistently. Take a look at the financial industry. The reason for this is plain enough: various regulations give them a competitive advantage, as they’re bigger and can more easily absorb the costs; that is, it wipes out their competitors, while leaving them intact (which in many cases is desireable).
As an example regarding oil companies, the current restrictions on nuclear power, and the irrational fear of nuclear power in the US, certainly benefits oil companies. They, thus, naturally have an monetary economic incentive to lobby for such regulation’s introduction, strenghtening, and enforcement.
I would also say they are not doing their “utmost”. Oil companies, just like almost any rational company only do things which make economic sense within their sphere. It would be doing more if they put the money they pay out in dividends into exploration, but that might not be the best use. There are smaller companies which explore which can be acquired. “Big Oil” is much more like IBM when it was still selling mainframes as its main business while the smaller guys were building personal computers and the internet.
This is not a bad thing, but only proves that big tends to be conservative (in the preservationist, status-quo sense), bureaucratic, and slow. The model works and it isn’t in their interest to break it even if it would mean more oil produced or less oil consumed as there are risks and opportunity costs.
(Big families tend to be conservative too – someone with a steady job and 9 kids in the midwest isn’t likely to move to California to participate in a gold, tech, or real-estate rush; I don’t think this as bad, merely what is in their best interest).
“…To whatever extent, it is possible for anyone else, anywhere in the world, to produce those additional 5 units, our firm simply does not have the option of choosing between 100 units at a price of $10 or 105 units at a price of $9. Its only choice is between 100 units at $9 or 105 units at $9.”
In fact, our firm does not have even this option. According to the scenario, its option is to supply 100 units at a price of $9 or 105 units at about perhaps $8, assuming the same elasticity of demand at a total industry volume of 110 units. Whatever volume it produces, competition supplying 5 units is assumed, and any increase in supply by our firm will lower the price further as you pointed out earlier.
“In such circumstances, it’s not at all unreasonable to expect that even our 100 percent supplier firm would be out there attempting to increase its output. Because if it does not increase its output and anyone else does, it ends up with the same lower price, but does so with less volume than it might have had and accordingly earns lower profits than it could have earned.”
With free entry into the market assumed, your points are valid. However, free entry into the hampered market is the issue. If the firm(s) in question can invoke the coercive arm of the state through regulation, to restrict entry to the market, either presenting a coercive monopoly or a cartel, then production can be restricted and profits increased in this inelastic market. There is no question that in a free market all industries will tend towards earning pure interest. However, with the help of the state in an inelastic market, cartels can persistently earn much more than interest and a tendency towards increases in production is not a priori.
You’re assuming that the competition can afford to sell 5 units for $8. Maybe 5 units for $9 is worthwhile, but for $8 it isn’t, and there won’t be any such competition.
It’s not actually my assumption, i’m just pointing out that the implication of this comment: “Its only choice is between 100 units at $9 or 105 units at $9″ is that if the firm ups its output to 105 units, then to still sell at $9 means that the competition must drop its output to zero (i don’t think this was being implied), or else the price must drop in the fashion i suggested. Either way, there was a significant point missing from the scenario.
I am very flattered by the fact that George Reisman has written a blog entry about my comments!
My instincts are with Paul Edwards comments above, though. Of course, monopoly profits are always ephemeral – if the price rises, at last resort, then the incentive is to consume more slowly, and so even a monopolist will lose of as a result of this, and so have an incentive to increase supply. However, surely there is a lag involved here?
On interventionism, sure, I take my cue from the likes of Rothbard and Roy Childs who showed that the growth of the interventionist state in the US was largely “promoted by big business for the purpose of further enrichment.” Their analysis makes sense to me.
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