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Calling on Brad DeLong

Guest post by John McGowan

I know Brad DeLong reads this blog because he picked up on my Amnesty International post some time back and, more recently, he told us about his own close encounter with Foucault’s work in response to one of Michael’s theory posts.  I also know that Professor DeLong is not running an Ann Landers service for the economically challenged.  But I am encouraged by his having just today posted a request to the physicists of the world to help him in his perplexity about the attraction between negative and positive particles.  So here’s my request for help from the economists of the world.  It comes in two parts.

1.  In its article on the energy bill last week, the Washington Post writes about “the oil and gas industry, which has seen record profits in recent months.” My question:  how does the rising price of oil translate into more profits for Exxon?  Let me explain why I don’t think that question is as dumb as it first appears.  (Of course, it may be just that dumb.  If so, that’s what I want to know.)

For whom is the cost of oil rising when it goes to $60 a barrel on the oil market?  In other words, is that $60 for refined oil, the kind that’s ready to go into my car, or is that for the crude stuff that Exxon then has to refine.  In other words, are Exxon’s costs rising at all—or is the rise of oil prices completely demand driven?  Who is buying what from whom on the oil market?  (Why would Exxon be buying refined oil from itself?  I thought the whole point of the vertical command of the industry by the big players was that they controlled the product from the moment it left the ground until the moment it got into my gas tank.  So where does the transaction that makes oil $60 a barrel take place in the process—and between what buyer and what seller?)

Furthermore, if the oil market is completely demand driven, why hasn’t the price gone up even further?  The American public has hardly reached its intolerance point for gasoline prices.  So far, the public’s gone little beyond grimace and bear it.  In other words, the companies have got the consumer by the balls.  Why not just squeeze harder?

A less crude way of putting this.  Princeton, at $50,000 a year—give or take five thousand—still has more people who want the product than it can supply.  Economic theory suggests Princeton should just raise its tuition to the point where it has 1000 applicants willing to pay that price for the 1000 places available in its freshman class.  Clearly, non-economic considerations—including, among other things, squeamishness about all-out capitalism in the education business and a desire for quality control in admissions—keep Princeton from following that strategy. But what keeps Exxon from maximizing what it charges for its product?

Finally, take the question in the reverse way.  If Exxon’s costs for oil are going up, that doesn’t translate into record profits unless they add a surcharge to their consumers.  If it cost Exxon $1.80 to produce a gallon of gas last year and they charged you and me $2.00, they get 20 cents profit.  If it costs them $2.00 to produce a gallon this year, and they sell it to you and me for $2.20, they should be showing the same—not increased—profits.

So record profits can only (it seems to me) come from one of three things.  Either they keep the percentage of profit the same and thus the increased revenue of more expensive gas means that the profits increase—with that increase being a larger sum of profit but not a higher profit margin. 10% of 6 million dollars is more than 10% of five million dollars.  Or Exxon uses the fact of higher costs to also slip in an increased profit margin.  They used to sell you a gallon at 10% above cost, but now they sell it at 11% above cost.  I do wish the financial pages of the newspaper would consistently distinguish between sums and percentages when talking of record profits.

The final possibility is that the oil futures market is pricing oil way beyond its current actual cost of production.  And if that’s the case, then high oil prices on that market are, at least in the short term, simply a bonanza for oil companies.  Maybe that’s the case.  I don’t know.

I think I have suitably demonstrated just how much I don’t know.  Needed: a basic explanation of how the oil business works.  And how that translates into what I am paying for gasoline and how the oil industry is enjoying record profits.

2. I have an even larger question.  Did the increased emphasis on “primary responsibility to the shareholders” since the mid-1980s bring about a marked change in what are considered acceptable profit margins for big American companies?

Here’s an anecdotal way to explain the import of this question.  I taught at the University of Rochester from 1984 to 1992.  When I arrived in Rochester in 1984, Kodak employed 54,000 people in the Rochester area.  In 1986 (or so), Kodak was the target of a hostile takeover bid because the company (an absolute model of a paternalistic employer and civic booster) was seen as “underperforming.” The company fought off that takeover bid, but within eighteen months the CEO had been fired, a new management team was brought in, and well before the recession of the early 1990s, Kodak had embarked on the downsizing that now has it employing less than 30,000 people in Rochester. 

Now, I know that Kodak’s transformation has many complex causes.  And perhaps it really was entirely due to the exigencies of a marketplace in which, unlike the oil companies, Kodak has just about no ability to raise the prices on any of its products even while the cost of employing Americans kept rising.  But Kodak’s first move toward cutting costs was not a response to direct competition or to the market’s resistance to its products.  It was about increasing the profit margin.  A once acceptable profit margin had now become unacceptable.  To what extent has the return of ruthless capitalism in the past twenty-five years been driven by this insistence that companies return less to their workers and their communities and more to their stockholders?  In other words, to what extent is the free market in companies (the free market in capital investments) hurting American workers more than a free global market in goods?  What could prevent a “race to the bottom,” with each company going to the group of investors willing to pay the most for it because they were also willing to wring the most profit out of it once they gained control?  How far have we already proceeded in this race to the bottom?  Are there numbers (i.e. about profit margins) that document that movement?

A final unrelated note.  Since I am trying to cajole Professor DeLong into the Ann Landers role, it would be churlish of me to ignore a similar request.  So, in next week’s post, I will take up the postmodernist’s call (in the comments to my post last week) for some reflection on Martha Nussbaum’s attack on the work of Judith Butler.  For those of you who like to come to class having actually done the reading, you can find the Nussbaum piece here.  But not to worry.  I have lots of experience talking about books my audience hasn’t read.  They usually assure me that they got a lot out of the talk anyway.  To which I, of course, must always reply: just think what you would have gotten out of it if you had read the material.

Posted by on 08/04 at 10:58 AM

  1. Mr. McGowan, there are too many issues in your post to address in the short time available for me to post this comment, but here are a few:
    1. Kodak’s return on sales and return on equity had in fact been declining for years when they drew the attention of corporate restructuring types.
    2.  The economy is not zero-sum, returns to shareholders do not come at the expense of employees and communities, all of whom are best served by profitable, growing businesses.
    3.  Capital follows returns, if an old, paternal company cannot generate returns to shareholders that are competitive with new, growing companies, the capital will be rationally reallocated to seek the greater return.  Those companies generating the greater return provide wealth available to employees, shareholders, and communities.  Companies with substandard returns consume wealth, leaving the entire economy poorer over time, while enriching in the short term those sinecured folks fortunate enough to be in the right place at the right time.
    I wish I had time to more completely discuss your questions.

    Posted by  on  08/04  at  01:11 PM

  2. Here are some points:

    1. Princeton prices: let us look at a simpler example—rock concert tickets. For popular bands, they are often priced way lower than the market clearing price, allowing for scalpers on the one hand and requiring significant non-monetary costs to fans (e.g., spending the night on a sidewalk in line) on the other. Why don’t the promoters just raise the prices and get the scalpers profit/value of not sitting on a cold sidewalk themselves? This is a much discussed (sorry, no url’s—google ‘concert ticket prices scalpers economics’ for a selection of articles), but one explanation is that the buzz that comes from selling out in 5 minutes and having scalpers make 200% is valuable publicity to the band. I would go with that for part of why Princeton is underpriced.

    2. Oil prices and profits: just a comment about LIFO (last in, first out) and FIFO (first in first out) accounting. Suppose a buy 1 barrel at $40 and then one barrel at $50. Then I sell 1 barrel for $45. Under FIFO, I just made $5, under LIFO I just lost $5. Under normal conditions, FIFO tends to make your inventory (not reserves, but product in your system) correctly priced while LIFO tends to make your current profits (or losses) correctly priced (and thus LIFO better follows actual cash flow). When prices are rising, FIFO exaggerates profits (because the rising value of your inventory is converted into profit). Note that if prices are rising sharply, a FIFO company can simultaneously record record profits and go bankrupt because it has no cash to meet obligations.

    I do not know whether oil companies use LIFO or FIFO, but my guess is FIFO because rising oil prices always seem to reult in higher profits and that is consistent with FIFO.

    Because oil companies have several weeks to several months supply in their systems (in tankers, in tanks, at refineries, in trucks, etc.) LIFO or FIFO (they have to choose one method and stick to it) concerns in the short run outway profit margins etc. and accurate estimates of those is hard to impossible for outsiders and not easy for insiders.

    The retail oil market seems at least somewhat competitive, so companies cannot just raise prices at will.

    Posted by  on  08/04  at  01:35 PM

  3. 1. A lot of the oil that ExxonMobil sells is oil that it already owns. When the price of oil goes up, it doesn’t have to pay anything extra for the oil it already owns, and it does pocket the extra revenue as it sells refinery products for the higher prices they then command…

    2. The broader question… This will be too long. Take a look at delong.typepad.com…

    Posted by  on  08/04  at  01:46 PM

  4. A lot of legitimate issues that Nussbaum raises -does Butler get the law wrong, is the obscure language necessary, what counts as feminist work- lose their force when Nussbaum starts to think of herself as Martin Luther King ("collaborates with evil"), which led some people to dismiss the whole article as some kind of weird brainfart on the part of an otherwise admirable thinker.  So I’m totally looking forward to a serious consideration of it!

    Posted by  on  08/04  at  03:10 PM

  5. Kodak is a bad example because its present economic straits are really caused by reason of the fact that it is in an outmoded industry.  Digital photography has gutted Kodak’s core business, which is the sale of chemicals and chemically treated products for processing photographs.  It has struggled to stay in the game, and may yet pull it off, but it is unlikely that it will ever return to the place in the market which it once occupied.

    Posted by Bill Altreuter  on  08/04  at  04:41 PM

  6. Yes, Kodak is a bad example, but Professor Delong addressed my larger question by ignoring the specific example of Kodak altogether. So I got what I wanted.  Check it out over at http://www.typepad.com/t/trackback/2947522.

    Anyway, my thanks to DeLong for taking my muddled question seriously.  And let’s thank the Lord that there isn’t a secondary market in Princeton admissions--at least not yet.  E-Bay is probably looking into the possibility.

    And I love getting comments on posts not even offered yet.  A preemptive strike!

    Posted by mcgowan  on  08/04  at  05:37 PM

  7. Dr Delong has a much more thorough explanation than I can provide, so consider this discussion supplemental to his.

    For any traded good, the price is set by the cheapest producer.  In most cases, this means that only the cheapest producers stay in business.  However, for natural resources, the cheapest producer can only produce a certain amount; he still sets the price, but he can set it at a level which give him extra profits (economic rents) and thus more expensive producers can also exist.

    The Saudis are the cheapest producers of oil; thus, they set the price.  Exxon is a more expensive producer; it makes more money as the oil price rises.

    So the question isn’t why Exxon doesn’t charge more; it’s why the Saudis don’t charge more.  The reason is that they want to maintain fairly stable demand for oil, since they have large reserves to sell in the future.  Higher oil prices lead to substitution away from oil; many of those substitutes are expensive and time-consuming to start using, but cheap to continue using (think nuclear power).  So the Saudis want to keep prices high enough to make money, but low enough that the market will still be there 10 years from now.

    Posted by  on  08/04  at  07:34 PM

  8. Kodak is not a bad example.  In 1984, it was not under threat from digital photography.

    Posted by  on  08/04  at  07:43 PM

  9. Total profit (or earnings) aren’t equal to profits distributed to shareholders; a portion is retained for reinvestment. One issue in the whole takeover-downsizing scenario is how to split the total between shareholders and reinvestment.

    Posted by  on  08/04  at  07:57 PM

  10. If I may.

    The $60 price is the price on the spot market, i.e the price to a consumer who suddenly decides he needs oil this month.

    However most serious users of oil do not rely on the spot market, they sign contracts months or even years in advance at a set price.

    Therefore while the spot price tells us a bit of the picture (what free oil is floating around waiting to be claimed) it tells us little about what the serious players in the market’s costs are as these sort of figures are “commerically confidential”

    So for example Exxon, will charge what they think the market will bear, since the Oil industry is now and ever has been a bit of a conspiracy between the various producers (no-one ever tries to seriously undercut anyone else, that’s not how you play oligopoly) rising headline prices are a glorious opportunity to make a few bucks, knowing full well that CNN/NBC/BBC reports will always stress the spot price.

    As us good Marxists know, the free in free market is just a good publicity phrase.

    Posted by Sonic  on  08/05  at  01:05 AM

  11. Re. Princeton prices, there’s one very good reason why Princeton’s management don’t just jack up the price: what economists call ‘peer effects’.

    Put crudely - students (or their parents) prefer classes with smart, motivated fellow students to classes full of the slow or disruptive. This atmosphere of learning (the chance to be taught alongside ‘good’ peers) is something people will pay a lot of money for. Hence the quality of Princeton’s ‘product’ doesn’t just depend on the quality of its teachers or facilities, but also on the quality of the students they admit.

    Here’s the catch - everyone knows that money and ‘smarts’ don’t always (or often?) go together. So if Princeton only admits the 1000 richest students, something funny will happen - the richest students won’t want to go there any more. Why? Because rich students aren’t paying to study alongside rich peers - they’re paying to study alongside the ‘brightest & the best’.

    This is why the scholarships and bursaries top colleges offer to poor-but-talented students aren’t charity at all - they’re sound business sense. The positive impact such students have on the learning environment hugely improves Princeton’s product. (Which they can then charge the richer-but-dumber students more money to consume.)

    So when John suggests that ‘non-economic considerations’ explain Princeton’s lower-than-expected price, he may be giving Princeton too much credit. They don’t want a price which will admit only the richest students - it simply isn’t in their interests to destroy their product for short term gain.

    For economics geeks only - this makes schools and colleges an example of clubs subject to ‘non-anonymous crowding’. New users impose consumption externalities on existing users, but the nature of the externality (positive or negative) depends on the characteristics of the new user. So smart kids impose a positive externality, less-smart kids a negative one.

    Posted by  on  08/05  at  05:14 AM

  12. Another question about oil from someone who barely escaped alive from Econ 101. What is the economic justification, beyond supply and demand, used when gasoline prices at the pump are raised almost instantly with the rise in oil prices on the spot market? To most of us economic illiterates out there, the words “price gouging” come to mind.

    Posted by  on  08/05  at  08:31 AM

  13. The official economic theory of the distinction between “supply and demand” and “price gouging” is:

    you say “potayto” and I say “potahto”

    Posted by dsquared  on  08/05  at  08:37 AM

  14. OT- anyone who liked “Adventures in Masulinity” will love this: http://www.livescience.com/humanbiology/050802_masculinity.html

    Posted by  on  08/05  at  10:09 AM

  15. Divine Right of Capital goes a long way towards answering your big question.  There is somwhere online a longish excerpt (in Tikkun, I believe).

    Posted by coturnix  on  08/05  at  08:11 PM

  16. I’m not an economist, not even close, but I’m deeply cynical about many claims that economists make, and I’ve done enough “law and economics” research on various issues to determine that any set of assumptions one economist will declare obvious and self-evident will be questioned and rejected by another.  If you start out with one set of fairly well defined social values, any smart economist can build impressive sounding economic theories around them; it’s working backwards that can get tricky - unpacking the ideology and values that are buried beneath a lot of putatively neutral theorizing. 

    And as long as I’m here: I know some very smart people who think exceedingly highly of Judith Butler’s work, but being of a rather pragmatic bent, I’d have to go with Nussbaum on this one.

    Posted by Ann Bartow  on  08/05  at  08:16 PM

  17. 2.  The economy is not zero-sum, returns to shareholders do not come at the expense of employees and communities, all of whom are best served by profitable, growing businesses.

    Posted by Chris Clarke  on  08/05  at  08:18 PM

  18. (Just couldn’t come up with a response as funny as the original.)

    Posted by Chris Clarke  on  08/05  at  08:19 PM

  19. Regarding Princeton prices—what Ali says makes complete sense…

    Imagine attending Yale along with a class full of GWB clones—who could, of course, afford the jacked up price.—How long before you transferred somewhere else? How long would Yale hang on to its illustrious reputation?

    Posted by  on  08/06  at  10:28 PM

  20. Who benefits most from the opening of the private colleges and universities to the smart kids of the lower and middle classes?  Does having a host of GWBs as alumni cheapen a Yale or Harvard degree, or does the cachet of that degree assist the offspring of the upperclasses in maintaining their air of superiority and help them retain position, power and prestige?

    Why should the public subsidize ‘elite’ private colleges and universities--and the hegemonies they perpetuate--through financial aid for students who would otherwise improve the finances and academics of more egalitarian public schools and universities?

    (Full disclosure:  I am the product of public schools, and my partner and I both work at an underfunded Massachusetts public college.)

    Posted by  on  08/07  at  09:43 AM

  21. <<...why hasn’t the price gone up even further?  The American public has hardly reached its intolerance point for gasoline prices.  So far, the public’s gone little beyond grimace and bear it.  In other words, the companies have got the consumer by the balls.  Why not just squeeze harder?>>

    Unless I’m missing something here, the answer to this seems easy enough.  Demand for gasoline is relatively inelastic.  So what?  Gasoline is a commodity - 87 octane is 87 octane, no matter who’s selling it - and Exxon is seldom the only game in town.  And even if they were, my tank is seldom so empty that I couldn’t simply drive to the next town along my way rather than pay whatever ludicrous rate Exxon would like to try charging me.  If Exxon decides to try squeezing consumers as hard as they think most of them will tolerate without giving up their cars in favor of some type of public transportation - for the sake of argument, let’s say they decide this is $10/gal - I’ll just drive to one of those other nice stations 200 yards further off the interstate exit who are undoubtedly more than willing to gain my business by continuing to sell me gasoline for under $3/gal.  Let’s see, which one is cheaper...Amoco? Shell?  For a difference of a few pennies a gallon, I may just go with whichever one has the shorter line, or that allows me to use my credit card at the pump, or has a nice convenience store attached, or some other attractive feature.  For a difference of $7/gal (or even much, much less), I don’t care if Exxon has hired Playboy bunnies to check my oil and squeegee my windshield, I’m going somewhere else.

    As far as explaining the intricacies of the internation oil market, and why some oil companies are experiencing either record profits or record profitability right now (whichever - or is it both? - is the case), I’m not really qualified to touch that one.

    Posted by Rob Leder  on  08/08  at  03:23 AM

  22. You have pointed out the rising oil price that can really affect each and every one of us here. I think you can save up something, for example, in using some fuel or oil-efficient parts like some that Car Parts Los Angeles and other shops or stores provides. In that way, your daily consumption or spending would gradually be lessen and be more efficient when it comes in times like this.

    Posted by  on  09/02  at  09:55 PM

  23. You are correct Brad. Any extra revenue that ExxonMobil gets, or creates, does get pocketed. They might say it doesn’t happen, but I know better as I have some people who are close to me who work in that industry. I’ve even seen some photos of some illegal works that go on in that industry because of a private investigation. The public is really held in a blind fold sometimes when it comes to industries like this.

    Posted by Roger  on  02/07  at  05:04 PM

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