Helping Tim Russert

The Commissar notes this exchange with Tim Russert and Samuel Bodman (the Secretary of Energy):

MR. RUSSERT: Mr. Secretary, if, if demand is up but supply is down, why are the profits so high?

MR. BODMAN: For that reason.
Story continues below ↓ advertisement

MR. RUSSERT: No, think about that.

MR. BODMAN: You know?

MR. RUSSERT: Play it out.

MR. BODMAN: Demand is up.

MR. RUSSERT: Correct.

MR. BODMAN: Right?

MR. RUSSERT: Right.

MR. BODMAN: So you’ve got more demand, you’re going to force price up.

You’ve got, you’ve got limited supply, and you’re going to have…

The Commissar says,

Someone draw him a picture.

Okay, no problem, here it is…well two actually. The first shows what happens when demand increases,

economicprofits1.JPG

Note that demand shifted from D1 to D2. As a result the price increases. How does a firm react in a competitive market? Well here is that picture as well,

economicprofits2.JPG

Note that as the price goes up from P1 to P2, due to the shift in demand, the firm expands production up to the point where (Short Run Marginal Cost) SMC = Price. The gray area represents the economic profits (profits over and above normal profits) that the firm would enjoy. In short, increasing profits when demand rises is precisely what we’d expect to see. This is elementary economics, not some sort of fancy schmancy cutting edge theory.

Now, in the case of an industry that is not competitive the pictures are different, but the basic logic is quite similar. Basically what happens is that a shift in demand to the right sends a signal to firms that marginal revenue is increasing. Marginal revenue is that revenue on the last unit produced. Given that the firm was initially in a position where marginal cost (the cost of the last unit produced) was equal to the old marginal revenue, the higher marginal revenue (due to the increased demand) says that production should increase. This would have the effect of bringing the two (marginal cost and marginal revenue) back into alignment. Since in the short run entry by compeititors is not possible, the firm enjoys economic profits.

However, those economic profits are what would entice entry (speaking in general terms). Thus, economic profits are important. Without them, there would be now entry. What happens to price once entry occurs depends on the cost structure of the industry in question over the long run. If costs are constant in the long run, then the price will eventually come back down. If the costs are increasing then the price will decline, but not to its previous level. And if costs are decreasing then the long run outcome is a lower price than the initial price. However, if we “take away” the economic profits then you get no entry.

If there is a problem with entry into a given market my first advice would be to look to the political situation. Either the government and/or voters have made entry into that market difficult. There are some “natural” barriers to entry such as large sunk costs, but I’m not sure that actually is the case with the oil industry. Large fixed costs could act as a barrier and that could be a problem in the oil industry, but when you have these kinds of dollars in profits, I think entry would tend to occur. Hence the likely culprit is the political situation.

MR. RUSSERT: But that’s a decision by the oil companies.

MR. BODMAN: No, it is not. That is a decision—those are—oil is traded every minute of every day, and it’s traded basically 24-by-seven. And it’s, it is determined in marketplaces in New York and London and Tokyo, all over the world. That’s the, the—the oil companies do not determine the price of oil; the producers determine the price of oil.

MR. RUSSERT: They determine, they determine, help determine the price at the pump. And if the, if their profits are going up, they have made a decision to add on the cost at the pump at such a level to guarantee higher profits.

Seems pretty clear that Mr. Russert got an F in elemantary economics.

FILED UNDER: Economics and Business, ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. PrestoPundit says:

    You’ll lovethis. Posted in Economics | Comments Off

  2. Great stuff helping to dispel the myth that the left wing press is all knowing and all powerful. This guy Russert is just plain dumb!

  3. OTB Moussaoui Spared Death Penalty Beltway Traffic JamHelping Tim Russert Earl Woods Dies at 74 Ann Coulter’s Useless Demagoguery What is an Expert? Michelle Malkin’s Sloppy Logic and Xenophobia Online Integrity Katrina Fatigue Rapper Big Hawk Shot to Death

  4. Laker44 says:

    My comment is not necessarily related to Russert, but it definitely stays with the incompetent theme. I just wanted to toss out an FYI that a new website is up hitting McCaskill for her misplaced values. I came across it this morning and thought I would share it with anyone who might be interested in checking it out. The address is http://www.CluelessClaire.com. It highlights McCaskill’s “out of touch” values and has a crossword puzzle that is rather amusing. As someone who has been keeping an eye on most of the Senate races, I enjoyed the site and thought maybe some of you would as well.

  5. Steve Verdon says:

    Actually I think this webpage is silly,

    http://www.cluelessclaire.com/news/article.aspx?ID=2241

    McCaskill is right in that exploring for oil in the lower 48 isn’t going to help much. The U.S. passed its peak production something like 30+ years ago. Search all you want, but it isn’t going to help and is most likely a waste of time and resources.

    As for ANWR, it would have a neglible impact on prices. Drill there for other reasons, but not to lower prices.

  6. legion says:

    Well, I think I see what Russert was having a problem with… If you make X profit by selling 10 units, and demand suddenly jumps to 20 units, you will now be making 2X in profits (assuming your costs stay the same). But if demand goes to 20 units (or even stays back at 10), and suddenly you’re making 5X in profits, then your profit margin – the amount you make on each unit – has increased.

    In short, it seems Timmah! can’t tell the difference between total profit & profit margin. Have I got that right?

  7. Herb says:

    WOW:

    With charts like this, I bet one could solve the “War on Terror”, the “Palestinian Problem”, “The Iraqi Political” Problems and The Social Security” problems or at least provide excuses for them.

    Go get em, economist of the World.

    Herb,

    You are being really stupid.

    S.V.

  8. Herb says:

    SV:

    Please post your own comments. Don’t make your snide thoughts a part of my comment.

    Thank You

    And by the way SV:

    I am sick and tired of paying through the nose for a product that is a vital part of the American way of life and watching some get filthy rich off of the misery they are causing the American people. And, I am sick of hearing all the excuses provided by some that justify this giant ripoff of everyone.

    Herb,

    I can edit any comment to my posts I like.

    The above graphs have nothing to do with you being sick, tired, or your nose. They merely explain what it going on. That is it. That you somehow think the laws of economics should be suspended because of your nose is not my problem.

  9. tom says:

    Herb: I want my cheap gas. Whaaa!
    Parent: Now, Herb. Settle down and stop acting like a baby.
    Herb: But I want my cheap gas. Itâ??s mine, mine, mine.
    Parent: If you donâ??t stop stomping your feet and acting like a spoiled brat you are going to bed with no dinner.
    Herb: No! Itâ??s not fair. Give me my cheap gas! Whaaa!

  10. Herb:

    You can always buy energy stocks mutual funds, you know.

  11. PAXALLES says:

    Outside the Beltway Helps Russert in the Beltway With Supply-Demand…

    Steve Verdon at Outside the Beltway helps Tim Russert of Meet the Press who seemed to be having trouble with basic supply and demand concepts as he pressed Secretary of Energy Bodman about oil company profits in the face of…

  12. Doug says:

    What I think will eventually happen is the Oil companies will get out of the “gas station” business for this very reason. They will become producers, not retailers.

    Exactly the same reason why they got out of the oil transport business after the Valdez spill. Bad PR.

    I would like to know the profit they make from the retail side vs. the production side.

  13. anjin-san says:

    Interesting that Bush cheerleader Herb is pissed about high gas prices. You reap what you sow dude…

  14. anjin-san says:

    Why would the oil produces want to get out of the gas station business after they went to all the trouble of wiping out the independents?

  15. Herb says:

    Tom:

    It looks like you have a lot of experience in throwing temper tantrums by the way you try to associate your own deficiencies to others.

    Sanity Inspector:

    Have you “Ever” considered that there may be others not as well healed as you.

    Anjin:

    If the likes of people like yourself who will never understand that the Democrats stopped the building of new refineries, stopped Oil Drilling, and such, in the name of the environmentalist wacko cause, we might be more energy independent than we are today.

    And I know that NO will be your answer.

  16. A Picture is Worth a Few Billion Words (or Dollars)…

    Steve Verdon noticed Tim Russert had a little trouble understanding oil company profits. Being the econ geek he is he……