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Some Further (Minor) Thoughts on the Phillips Curve

September 6, 2017 3 comments

Before I begin, let me say that if you haven’t read yesterday’s article, please do because it represents the important argument: the Phillips Curve doesn’t need rehabilitating, because it is working fine. In fact, I would argue that the Phillips Curve – relating wages to unemployment – is a remarkably accurate economic model prediction. The key chart from that article I reproduce here, but the article (which is brief) is worth reading.

Following my publication of that article, I had a few more thoughts that are worth discussing on this topic.

The first is historical. It’s incredibly frustrating to read article after article incorrectly stating what the Phillips Curve is supposed to relate. Of course one writer learns from another writer until what is incorrect becomes ‘common knowledge.’ I was fortunate in that, 30 years ago, I had excellent Economics professors at Trinity University in San Antonio, and I was reflecting on that fact when I said to myself “I wonder if Samuelson had it right?”

So I dug out my copy of Economics by Samuelson and Nordhaus (the best-selling textbook of all time, I believe, and the de rigeur Intro to Economics textbook for generations of economists). My copy is the 12th Edition, so perhaps they have corrected this since then…but on page 247, there it is – the Phillips Curve illustrated as a “tradeoff between inflation and unemployment.” Maybe that is where this error really propagated – with a Nobel Prize-winning economist making an error in his incredibly widely-read text! Interestingly, the authors don’t reference the original Phillips work, but refer to “writers in the 1960s” who made that connection, so to be fair to Samuelson and Nordhaus they were possibly already repeating an error that had been made even earlier.

My second point is artistic. In yesterday’s article, I said “The Phillips Curve…simply says that when labor is in short supply, its price goes up. In other words: labor, like everything else, is traded in the context of supply and demand,…” But students of economics will note that the Phillips Curve seems to obfuscate this relationship, because it is sloping the wrong way for a supply curve – which should slope up and to the right rather than down and to the right. This can be remedied by expressing the x-axis of the Phillips Curve differently – making it the quantity of labor demanded rather than the quantity of labor not demanded…which is what the unemployment rate is. So the plot of wage inflation as a function of the Employment Rate (as opposed to the Unemployment Rate) has the expected shape of a supply curve. More labor is supplied when the prices rise.

Again, this is nuance and not a really important point unless you want your economics to be pretty.

My third point, though, is important. One member of the bow-tied fraternity of Ph.D. economists told me through a friend that “the Phillips Curve has evolved to the relationship between Unemployment and general prices, not simply wages.” I am skeptical of any “evolution” that causes the offspring to be worse-adapted to the environment, but moreover I would argue that whoever led this “evolution” (and as I said above, it looks like it happened in the 1960s) didn’t really understand the way the economy (and in particular, business) works.

There is every reason to think that wages should be tied to available labor supply because one is the price of the other. That’s Microeconomics 101. But if unemployment is going to be a good indicator of generalized price inflation too, then it means that prices in the economy are essentially set as the price of the labor input plus a spread for profit. That is not at all how prices are set. Picture the businessperson deciding how to set prices. According to the “evolved Phillips Curve” understanding, this business owner looks at the wages he/she is paying and then sets the price of the product. But that’s crazy. A business owner considers labor as one input, as well as all of the other inputs, improvements in productivity in producing this good or service in question, competitive pressures, and the general state of the national and local economy. It would be incredible if all of these factors canceled out except for wage inflation, wouldn’t it? So in short, while I would expect that unemployment might have some explanatory power for inflation, I wouldn’t expect that explanatory power to be very strong. And, in fact, it isn’t. (But this isn’t new – it never has had any power.)

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The Phillips Curve is Working Just Fine, Thanks

September 5, 2017 1 comment

I must say that it is discouraging how often I have to write about the Phillips Curve.

The Phillips Curve is a very simple idea and a very powerful model. It simply says that when labor is in short supply, its price goes up. In other words: labor, like everything else, is traded in the context of supply and demand, and the price is sensitive to the balance of supply and demand.

Somewhere along the line, people decided that what Phillips really meant was that low unemployment caused consumer price inflation. It turns out that doesn’t really work (see chart, source BLS, showing unemployment versus CPI since 1997).

Accordingly, since the Phillips Curve is “broken,” lots of work has been done to resurrect it by “augmenting” it with expectations. This also does not work, although if you add enough variables to any model you will eventually get a decent fit.

And so here we are, with Federal Reserve officials and blue-chip economists alike bemoaning that the Fed has “only one model, and it’s broken,” when it never really worked in the first place. (Incidentally, the monetary model that relates money and velocity (via interest rates) to the price level works quite well, but apparently they haven’t gotten around to rediscovering monetarism at the Fed).

But the problem is not in our stars, but in ourselves. There is nothing wrong with the Phillips Curve. The title of William Phillips’ original paper is “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957.” Note that there is nothing in that title about consumer inflation! Here is the actual Phillips Curve in the US over the last 20 years, relating the Unemployment Rate to wages 9 months later.

The trendline here is a simple power function and actually resembles the shape of Phillips’ original curve. The R-squared of 0.91, I think, sufficiently rehabilitates Phillips. Don’t you?

I haven’t done anything tricky here. The Atlanta Fed Wage Growth Tracker is a relevant measure of wages which tracks the change in the wages of continuously-employed persons, and so avoids composition effects such as the fact that when unemployment drops, lower-quality workers (who earn lower wages) are the last to be hired. The 9-month lag is a reasonable response time for employers to respond to labor conditions when they are changing rapidly such as in 2009…but even with no lag, the R-squared is still 0.73 or so, despite the rapid changes in the Unemployment Rate in 2008-09.

So let Phillips rest in peace with his considerable contribution in place. Blame the lack of inflation on someone else.

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Profits and Health Care: A Beneficial Connection

March 17, 2017 4 comments

I usually try to avoid political commentary in this space, because it has become so personal to so many people. If I point out that a particular program of the “left” is smart, or cleverly put together, then half of my readership is annoyed; if I point out the same about the right, then half of my readership is angry. It doesn’t really make sense to waste article space except on those occasions when a policy has a clear effect on inflation over time, such as when the structure of the ACA made it clear that it would put upward pressure on inflation (as I pointed out in 2013) or in response to someone else’s flawed analysis of a policy, as I did last year when I tackled the San Francisco Fed for their weak argument about how the ACA would hold down inflation because the government would demand lower prices. Actually, there is no policy I have written about more than the ACA over the years – but again, this was economic commentary and not political commentary.

This article will be short, but different in that I am writing it to express frustration with the absolute lack of intellectual clarity on the part of the Republicans in making a particular argument that immediately impacts the debate over health care but also extends far into other policies. And, because the argument is simple, direct, and has tremendous empirical support, I couldn’t restrain myself. I expect this article will not be picked up and syndicated in its usual channels since it isn’t directly about economics or markets, but it needed to be said.

I’ve been stewing about this topic since Tuesday (March 14th), when I happened to catch part of the daily White House press briefing. Press Secretary Sean Spicer was asked a question about the President’s health care proposal, and tap danced away from the question:

Q    Thanks, Sean.  You mentioned the call with the CEO of Anthem Health.  Can you tell me what this proposal of the President means for health insurance companies?  Will their profits go up or down under the President’s proposal?

SPICER:  Well, I don’t think that’s been the focus of the President’s proposal.  It’s not about them, it’s about patients.  But I think what it means for them is that they finally get to create more choice and more plans and allow people to choose a plan that fits them.  Right now, they don’t have that choice.  And, frankly, in more and more markets, companies like Anthem, UnitedHealth, Signa are pulling out — Aetna — because they don’t have the choice and because of the government mandate.  I think what we want to do is allow competition and choice to exist so that they can offer more options for the American people.

Q    But will those companies make more money under the President’s plan or less?

SPICER:  I don’t know the answer to that.  That’s not been the focus of what we’re doing now.  And at the end of the day, right now they’re pulling out of market after market, leaving the American people with fewer and fewer choices.  So right now it’s not a question of — from the last I checked, I think many of them were doing pretty well, but it’s the American people and its patients that are losing under the current system.  So I think that there’s a way you can do a little of both.

Spicer’s response was the usual drivel that the Republicans have adopted when they run in fear from any question that includes the word “profits.” To summarize, the question was basically, “you’re doing this to throw a sop to fat-cat insurance companies, aren’t you?” and the answer was “we don’t think about that. No idea. Profits? Who said anything about profits? It’s about patients and choice. And, if anyone gets more profits, it wasn’t on purpose and we didn’t have anything to do with it.”

But this was actually a softball question, and the answer ought to have been something like this:

Q    But will those companies make more money under the President’s plan or less?

BIZARRO SPICER: Well, I hope so. After all, the insurance companies want every person in America to have health care – which is the same thing that we want – because the more people they sell their product to, the more money they can make. The insurance companies want to sell insurance to every person in the U.S. The insurance companies also want costs to be lower, and constantly strive to lower the cost of care, because the lower that costs are, the more profit they can make in the short run. But they don’t want lower costs at the expense of health – clearly, the best outcome for their profits is that most people covered by insurance are healthy and so don’t require the insurance they’ve paid for. So, if we just get out of the way and let companies strive for better profits, we are likely to get more coverage, lower costs, and a healthier population, and that is the goal of the President’s plan.

The reason we don’t already have these things is that laws we have previously passed don’t allow insurance companies to offer certain plans, to certain people, which both sides want but which politicians think are “unfair” for one reason or another. Trying to create a certain preconceived Utopian outcome while limiting profits of insurance companies is what caused this mess in the first place.

If you want to beautify gardens in this city, does it make sense to limit the amount of money that gardeners can make? If you did, you would find fewer gardens got tended, and gardeners would not strive to make improvements that they didn’t get paid for. We can see this clearly with gardeners. Why is it so hard to understand with the companies that tend to the nation’s health? Next question.

For some reason, Republicans think that saying “profits are good” is the same thing as saying “greed is good” and leads to caricatures of conservatives as cigar-smoking industrialists. But while at some level it is the desire for a better material outcome – which I suppose is greed, but aren’t there degrees of greed? – that drives the desire for profit, we cannot dismiss the power of self-interest as a motive force that has the effect of improving societal outcomes. “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest,” after all.

Of course, Republicans must also remember that profit without competition is a different animal. If an insurance company creates an innovation that lowers medical care costs, but does not face competitive pressure, then the benefit of the innovation accrues to the company alone. There is no pressure in such circumstances for the company to lower the price to the customer. But consider what happened to air fares after the deregulation of 1978, or to the cost of telephone service when the AT&T monopoly was broken up in 1984, as competition was allowed and even encouraged. Competition, and the more brutal the better, is what causes companies to strive for an edge through innovation, and it’s also what causes the benefit of that edge to eventually be accrued by the end customer. The government didn’t invent cell phones. Motorola did, in order to try and gain an edge against AT&T,[1] but until the telephone monopoly was broken up there were no commercial versions of the cell phone. The first cell phones cost $10,000 in 1983, about $25,000 in today’s dollars, but now they are ubiquitous and cost about 2% as much in real terms. But this didn’t happen because of a government program to drive down the cost of cell phones. It was the profit motive, combined with competition. All that government did was create the conditions that allowed innovation and competition to happen. And wouldn’t we like health care to be as ubiquitous and cheap as cell phones are?

This is not a hard thing to get right. It isn’t hard for people to understand. But for some reason, it seems incredibly hard for politicians to believe.

Note that nothing I have written here should be construed as an opinion about the President’s health care plan, which I have not read. My remarks are only meant to reflect on the utter inability of Republicans to properly convey the reasons that a different approach – one where the government’s involvement is lessened, rather than increased – would make more sense.

[1] The first cell phone call was made by the inventor, Martin Cooper at Motorola, who called his competition with it: the head of the cellular program at AT&T. According to him, he said “Joel, I’m calling you from a cellular phone, a real cellular phone, a handheld, portable, real cellular phone” and he said it got really quiet on the other end of the line.

Good Models and Bad Models

I have recently begun to spend a fair amount of time explaining the difference between a “good model” and a “bad model;” it seemed to me that this was a reasonable topic to put on the blog.

The difference between a good model and a bad model isn’t as obvious as it seems. Many people think that a “good model” is one that makes correct predictions, and a “bad model” is one that makes bad predictions. But that is not the case, and understanding why it isn’t the case is important for economists and econometricians. Frankly, I suspect that many economists can’t articulate the difference between a good model and a bad model…and that’s why we have so many bad models floating around.

The definition is simple. A good model is one which makes good predictions if high-quality inputs are given to the model; a bad model is one in which even the correct inputs doesn’t result in good predictions. At the limit, a model that produces predictions that are insensitive to the quality of the inputs – that is, whose predictions are just as accurate no matter what the inputs are – is pure superstition.

For example, a model of the weather that depends on casting chicken bones and rat entrails is a pretty bad model since the arrangement of such articles is not likely to bear upon the likelihood of rain. On the other hand, a model used to forecast the price of oil in five years as a function of the supply and demand of oil in five years is probably an excellent model, even though it isn’t likely to be accurate because those are difficult inputs to know. One feature of a good model, then, is that the forecaster’s attention should shift to the forecasting of the inputs.

This distinction is relevant to the current state of practical economics because of the enormous difference in the quality of “Keynesian” models (such as the expectations-augmented Phillips curve approach) and of monetarist models. The simplest such monetarist model is shown below. It relates the GDP-adjusted quantity of money to the level of prices.

This chart does not incorporate changes in money velocity (which show up as deviations between the two lines), and yet you can see the quality of the model: if you had known in 1948 the size of the economy in 2008, and the quantity of M2 money there would be in 2008, then you would have had a very accurate prediction of the cumulative rate of inflation over that 60-year period. We can improve further on this model by noting that velocity is not random, but rather is causally related to interest rates. And so we can state the following: if we had known in 2007 that the Fed was going to vastly expand its balance sheet, causing money supply to grow at nearly a 10% rate y/y in mid-2009, but at the same time 5-year interest rates would be forced from 5% to 1.2% in late 2010, then we would have forecast inflation to decline sharply over that period. The chart below shows a forecast of the GDP deflator, based on a simple model of money velocity that was calibrated on 1977-1997 (so that this is all out-of-sample).

That’s a good model. Now, even solid monetarists didn’t forecast that inflation would fall as far as it did – but that’s not a failure of the model but a failure of imagination. In 2007, no one suspected that 5-year interest rates would be scraping 1% before long!

Contrariwise, the E-A-Phillips Curve model has a truly disastrous forecasting history. I wrote an article in 2012 in which I highlighted Goldman Sachs’ massive miss from such a model, and their attempts to resuscitate it. In that article, I quoted these ivory tower economists as saying:

“Economic principles suggest that core inflation is driven by two main factors. First, actual inflation depends on inflation expectations, which might have both a forward-looking and a backward-looking component. Second, inflation depends on the extent of slack (or spare capacity) in the economy. This is most intuitive in the labor market: high unemployment means that many workers are looking for jobs, which in turn tends to weigh on wages and prices. This relationship between inflation, expectations of inflation and slack is called the “Phillips curve.”

You may recognize these two “main factors” as being the two that were thoroughly debunked by the five economists earlier this month, but the article I wrote is worth re-reading because it describes how the economists re-calibrated. Note that the economists were not changing the model inputs, or saying that the forecasted inputs were wrong. The problem was that even with the right inputs, they got the wrong output…and that meant in their minds that the model should be recalibrated.

But that’s the wrong conclusion. It isn’t that a good model gave bad projections; in this case the model is a bad model. Even having the actual data – knowing that the economy had massive slack and there had been sharp declines in inflation expectations – the model completely missed the upturn in inflation that actually happened because that outcome was inconsistent with the model.

It is probably unfair of me to continue to beat on this topic, because the question has been settled. However, I suspect that many economists will continue to resist the conclusion, and will continue to rely on bad, and indeed discredited, models. And that takes the “bad model” issue one step deeper. If the production of bad predictions even given good inputs means the model is bad, then perhaps relying on bad models when better ones are available means the economist is bad?

August, Productivity, and Prices

August 11, 2016 4 comments

I really don’t like August. It’s nothing about the weather, or the fact that the kids are really ready to be back in school (but aren’t). I just really can’t stand the monkey business. August is, after December, probably the month in which liquidity is the thinnest; in a world with thousands of hedge funds this means that if there is any new information the market tends to have dramatic swings. More to the point, it means that if there is not any new information, the speculators make their own swings. A case in point today was the massive 5% rally in energy futures from their lows of the day back to the recent highs. There was no news of note – the IEA said that demand will balance the oil market later this year, but they have said that in each of the last couple of months too. And the move was linear, as if there had been news.

Don’t get me wrong, I don’t care if traders monkey around with prices in the short run. They can’t change the underlying supply and demand imbalance and so it’s just noise trading for noise trading’s sake. What bothers me is that I have to take time out of my day to go and try to find out whether there is news that I should know. And that’s annoying.

But my whining is not the main reason for this column today. I am overdue to write about some of the inflation-related developments that bear comment. I’ll address one of them today. (Next week, I will probably tackle another – but Tuesday is also CPI day, so I’ll post my usual tweet summary. Incidentally, I’m scheduled to be on What Did You Miss? on Bloomberg TV at 4pm ET on Tuesday – check your local listings).

I don’t spend a lot of time worrying about productivity (other than my own, and that of my employees). We are so bad at measuring productivity that the official data are revised for many years after their release. For example, the “productivity miracle” of the late 1990s, which drove the Internet bubble and the equity boom into the end of the century, was eventually revised away almost completely. It never happened.

The problem that a lot of people have with thinking about productivity is that they confuse the level of productivity with its pace of increase. So someone will say “of course the Internet changed everything and we got more productive,” when the real question is whether the pace of productivity increase accelerated. We are always getting more productive over time. There are always new innovations. What we need to know is whether those innovations and cost savings are happening more quickly than they used to, or more slowly. And, since the national accounts are exquisitely bad at picking up new forms of economic activity, and at measuring things like intellectual property development, it is always almost impossible to reject in real time the hypothesis that “nothing is changing about the rate of productivity growth.” Therefore, I don’t spend much time worrying about it.

But, that being said, we should realize that if there is a change in the rate of productivity growth it has implications for growth, but also for inflation. And recent productivity numbers, combined with the a priori predictions in some quarters that the global economy is entering a slow-productivity phase, have started to draw attention.

Most of that attention is focused on the fact that poor productivity growth lowers overall real output. The mechanism there is straightforward: productivity growth plus population growth equals real economic output growth. (Technically, more than just population growth it is working-age population growth times labor force participation, but the point is that it’s an increase in the number of workers, compounded by the increase in each worker’s productivity, that increases real output). Especially if a populist backlash in the US against immigration causes labor force growth to slow, a slower rate of productivity growth would compound the problem of how to grow real economic growth at anything like the rate necessary to support equity markets or, for that matter, the national debt.

But there hasn’t been as much focus on the other problem of low productivity growth, if indeed we are entering into that sort of era. The other problem is that low productivity growth causes higher prices, all else equal. That mechanism is also straightforward. We know that money growth plus the change in money velocity equals real output growth plus an increase in prices: that is, MV≡PQ. If velocity is mean-reverting, then the decline in real growth precipitated by a decline in labor productivity, in the context of an unchanged rate of increase in the money supply, implies higher prices. That is, if ΔM is constant and ΔV is zero and ΔQ declines, then ΔP must increase.

One partial offset to this is the fact that a permanent decline in productivity growth rates would lower the equilibrium real interest rate, which would lower the equilibrium money velocity. But that is a one-time shift while the change in trend output would be lasting.

In fact, it wouldn’t be unreasonable to suppose that the change in interest rates we have seen in the last few years is mostly cyclical but may also be partly secular. This would imply a lower equilibrium level of interest rates (although I don’t mean to imply that anything is near equilibrium these days), and a lower equilibrium level of monetary velocity. But there are a lot of “ifs” in that statement.

The biggest “if” of all, of course, is whether there really is a permanent or semi-permanent down-shift in long-term productivity growth. I don’t have a strong opinion on that, although I suspect it’s more likely true that the current angst over low productivity growth rates is just the flip side of the 1990s ebullience about productivity. We’ll know for sure…in about a decade.

Obamacare, Monopsonies, and Inflation – Nice Try!

June 9, 2016 2 comments

Recently, the San Francisco Federal Reserve published an Economic Letter in which they described why “Medicare Payment Cuts Continue to Restrain Inflation.” Their summary is:

“A steady downward trend in health-care services price inflation over the past decade has been a major factor holding down core inflation. Much of this downward trend reflects lower payments from public insurance programs. Looking ahead, current legislative guidelines imply considerable restraint on future public insurance payment growth. Therefore, overall health-care services price inflation is unlikely to rebound and appears likely to continue to be a drag on inflation.”

The article is worth reading. But I always have a somewhat uncomfortable reaction to pieces like this. On the one hand, what the authors are discussing is well known: healthcare services held down PCE inflation, and core CPI inflation, due to sequestration. Even Ben Bernanke knew that, and it was one reason that it was so baffling that the Fed was focused on declining core inflation in 2012-2014 when we knew why core was being dragged lower – and it was these temporary effects (see chart, source Bloomberg, showing core and Median CPI).

baffling

But okay, perhaps the San Francisco Fed is now supplying the reason: these were not one-off effects, they suggest; instead, “current legislative guidelines” (i.e., the master plan for Obamacare) are going to continue to restrain payments in the future. Ergo, prepare for extended lowflation.

This is where my discomfort comes in. The article combines these well-known things with questionable (at best) assumptions about the future. In this latter category the screaming assumption is the Medicare can affect prices simply by choosing to pay different prices. In a static analysis that’s true, of course. But it strikes me as extremely unlikely in the long run.

It’s a classic monopsonist pricing analysis. Just as “monopoly” is a term to describe a market with just one dominant seller, “monopsony” describes a market with just one dominant buyer. The chart below (By SilverStar at English Wikipedia, CC BY 2.5, https://commons.wikimedia.org/w/index.php?curid=13863070) illustrates the classic monopsony outcome.

217px-Monopsony-static-partial-equilibrium.svg

The monopsonist forces an equilibrium based on the marginal revenue product of what it is buying, compared to the marginal cost, at point A. This results in the market being cleared at point M, at a quantity L and a price w, as distinct from the price (w’) and quantity (L’) that would be determined by the competitive-market equilibrium C. So, just as the San Fran Fed economists have it, a monopsonist (like Medicare) forces a lower price and a lower quantity of healthcare consumed (they don’t talk so much about this part but it’s a key to the ‘healthcare cost containment’ assumptions of the ACA neé Obamacare). Straight out of the book!

But that’s true only in a static equilibrium case. I admit that I wasn’t able to find anything relevant in my Varian text, but plain common-sense (and observation of the real world) tells us that over time, the supply of goods and services to the monopsonist responds to the actual price the monopsonist pays. That is, supply decreases because period t+1 supply is related to the reward offered in period t. There is no futures market for medical care services; there is no way for a medical student to hedge future earnings in case they fall. The way the prospective medical student responds to declining wages in the medical profession is to eschew attending medical school. This changes the supply curve in period t+1.

Any other outcome, in fact, would lead to a weird conclusion (at least, I think it’s weird; Bernie Sanders may not): it would suggest that the government should take over the purchase and distribution of all goods, since they could hold prices down by doing so. In other words, full-on socialism. But…we know from experience that pure socialist regimes tend to produce higher rates of inflation (Venezuela, anyone?), and one can hardly help but notice that when the government competes with private industry – for example, in the provision of express mail service – the government tends to lose on price and quality.

In short, I find it very hard to believe that mere “legislative guidelines” can restrain inflation in medical care, in the long run.

Don’t Forget Oil Demand Elasticity!

April 18, 2016 3 comments

The big story of the weekend was that a meeting of OPEC and non-OPEC producers, at which an agreement was supposed to be signed to freeze oil production at recent levels, ended without an agreement being signed. This was not an enormous surprise, since Iran didn’t even attend the conference and the Saudis had said they wouldn’t sign unless Iran agreed, but oil prices initially took a significant hit before recovering some later in the day.

The economic significance of the lack of agreement is fairly small; most producers are producing near their maximum output, except for important non-attendees like the United States and Iran. (The Saudis claim to be able to put 1mm barrels per day online in short order, too).  But the psychological significance was thought to be important.

I’m not so sure about the importance of mind-games in an efficient global market for a commodity product. The market is oversupplied, by a significant amount, and no amount of posturing will change that. However, basic economics may.

Overlooked by many is the fact that OPEC’s problem is one that automatically diminishes over time even if OPEC does nothing. This is because the demand for oil is short-term inelastic, but long-term elastic.

The elasticity of demand describes how quickly the quantity demanded responds to price. If demand is very elastic, then changes in price cause large changes on the quantity demanded. On the other hand, inelastic demand curves indicate that the quantity demanded changes very little when the price on offer changes.

The elasticity of demand has a very significant consequence for the question of how revenues change when prices change. Revenue is simply price times quantity. So, if a small change in price causes a large change in quantity (that is, an elastic demand curve), it is a good strategy (for example, as an individual company) to cut one’s price: the company will sell lots more product and give up only a little revenue on each one, so that total revenues rise with price declines if a producer faces an elastic demand curve. On the other hand, if demand is inelastic, then a price cut doesn’t change the quantity sold very much, but decreases revenue on each unit. If a producer faces an inelastic supply curve, total revenues decline with price decreases. And, conversely, total revenues increase with price increases in such a case. This is the reason that cartelization of the oil industry is an apparently attractive strategy: oil demand is, at least in the short-run, price inelastic. If gasoline prices rise $1 per gallon next week, you will still drive almost as much as before.

But static equilibria cannot fully describe dynamic markets! It turns out that for most products, demand elasticity in the long-run is higher, and often much higher, than in the short run. Consumers adjust to changing prices by adjusting their consumption mix! This is also true with energy markets: while you won’t drive a lot less next week if gasoline prices are much higher, if they stay higher you will start to carpool, buy more energy-efficient vehicles, and so on. This is one reason that cartelization ends up failing. In the short run, it makes sense to band together and hike prices, raising overall revenue, but this has deleterious effects on long-run revenue and creates incentives to cheat to grab more of the (diminishing) demand.

Analysis of the energy markets tends to focus on supply, but as prices increase and decrease over extended periods of time, it is important to remember that demand eventually responds. From 2011 until mid-2014, retail gasoline averaged about $3.50 per gallon (see chart, source Bloomberg). But it has been below that level for almost two years, and averaged more like $2.30 per gallon since then.

retailgasoline

Similarly, WTI crude oil averaged around $100/bbl in 2011-mid2014, but only about $60 since then. And most of that was well below $60. The picture for Brent is of course very similar.

wtic

In the short run, with inelastic demand, these large declines represent a very large drop in OPEC producer revenues. But in the long run – and after two years, we are much closer to the long run – demand will increase even if the global economy doesn’t grow at all because there is a demand response to lower prices. OPEC, in other words, initially sold the same amount of oil at lower prices, but as time passes they will sell larger amounts of oil at these lower prices. While that’s not as good as selling those larger amounts of oil at higher prices, it is better than what it had been after the initial, sharp decline.

So oil producers will have more total revenue over the next year, even if price doesn’t change and even if the global economy stops growing, than they did last year. The need for a production freeze becomes less urgent all the time.

Of course, the supply overhang is huge, and it won’t go away overnight and probably won’t go away from demand response alone. But, as we are dealing with the long run, we shouldn’t neglect the demand response, either.

Categories: Commodities, Economics, Theory
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