Rent Seeking, Strategic Behavior and Gasoline Prices
Not a very exciting sounding topic, but it does deal with something that is close to just about every adult out there, gasoline prices. Changes in gasoline prices affect all of us, and hence it is something most people should, in my view, know more about, but usually don’t. The notion of rent seeking is where a person, a group of people, a corporation, etc. seek to increase their profits via the political process instead of doing things like making and selling their goods/services. For example, you have an industry and the industry association gets together and decides that it would be better for those in the industry if new entrants could be prevented or reduced, but how to do it? Licensing. You go to politicians and point out that there is potential or even real problems in the industry from shoddy work, dishonest operators, etc. The solution is a license after meeting certain requirements. And bingo, now you have fewer entrants because entry into the industry is now costly. If you are already in the industry (and especially if you are grandfathered in) you now improved your market power. Market power translates into an ability to raise prices and hence increase your profits. However, these new profits are not from producing more, being more efficient, etc. These profits are for all intents and purposes unearned, hence they are called rents.
Now that is a nice description of the problem, but does it happen in reality? The answer is yes. The other day the Foundation for Taxpayer and Consumer Rights (FTRC) released a press release claiming that oil companies intentionally limited refining capacity to drive up gasoline prices. To me this is not at all suprising.
The three internal memos from Mobil, Chevron, and Texaco (Click here to read the memos.) show different ways the oil giants closed down refining capacity and drove independent refiners out of business. The confidential memos demonstrate a nationwide effort by American Petroleum Institute, the lobbying and research arm of the oil industry, to encourage the major refiners to close their refineries in the mid-1990s in order to raise the price at the pump.
So oil companies are behaving in a strategic manner to improve their profits. Nothing new here, IMO. In fact, I’d say that anybody who is shocked, surprised, or upset by this is a naive fool. This is what companies do. No company wants competition. Every company would love to be a monopolist. The Mobil memo for instance seems to be nothing more than an appraisal of another competing refinery starting back up. The Texaco memo on the other hand looks like a nice example of rent seeking in that it discusses using proposals about establishing tighter fuel standards to their advantage in terms of reducing supply and thereby driving up prices. Given the description and example of rent seeking in the first paragraph of this post, it looks like nothing other than good old rent seeking.
In short what we have are oil companies using environmental legislation to their benefit. So when the FTCR and their consultant Tim Hamilton say things like the following,
“It’s now obvious to most Americans that we have a refinery shortage,” said petroleum consultant Tim Hamilton, who authored a recent report about oil company price gouging for FTCR. (Click here to read the report.) “To point to the environmental laws as the cause simply misses the fact that it was the major oil companies, not the environmental groups, that used the regulatory process to create artificial shortages and limit competition.”
it strikes me as monumentally naive. Are oil companies to blame? Sure, but at the same time the oil companies used the very same environmental laws to do their dirty work. So this idea that environmental laws and regulations played no part is bordering on the stupid. In reading the report, Promoting $3 at the Pump in California I see some dubious assertions. For example,
Increases in the prices charged for oil by OPEC countries are not primarily responsible for the dramatic increase in gasoline prices in California. Much of CaliforniaÃ¢€™s crude oil is harvested locally by major refiners who control their own fields. OPEC nations only supply approximately 20% of the oil delivered to refineries in California. Fields controlled by the oil companies in California or Alaska provide the majority (66%) with the remaining 14% coming from non-OPEC foreign locations (Figure 2).
This indicates a complete lack of understanding of economics and the fact that the oil market is a global market. If oil produced in California has a price of say $20 in California, but it could be sold in another part of the world for $50 then you sell in another part of the world. The result is that prices would rise in California and fall the other part of the world producing a global price. This is what we observe today. So noting that oil that is refined in/for the California gasoline market comes mostly from California is pretty much irrelevant.
California consumers will pay an estimated increase of $15.5 billion more at the pump in 2005 than in 2000 because of profiteering by oil companies and governmentÃ¢€™s failure to act. (Figure 5).
Yes, and there are only two types of gasoline that can be sold in CA, and those types cannot be sold anywhere else. Hence this creates a local market and since retooling a refinery is costly it gives those refiners who produce for the CA market market power (i.e. the ability to raise prices).
No public evidence exists of substantive increases from 2000 to 2005 to oil companies in the cost of a) producing crude oil; b) refining oil into gasoline or diesel; or c) transporting the refined products to market.
Geez, anybody who suffered through an elementary microeconomics class would know that price is not determined just by costs, but by demand and supply (costs). Looking at just the costs and ignoring the possible changes in demand gives only part of the picture. Also, we’d want to look not just at the cost of refining, but the industry composition as well. Are firms shutting down? If this is the case than that also gives the remaining firms market power as well.
And this notion that it is bad for one firm to engage in strategic behavior that drives out other firms is just ridiculous. It is ridiculous in that is what all firms try to do. They want to be the successful firm, get rid of the compeitition and increase their market share if it is percieved as being good for profits.
The basic idea in all of this is that the oil companies like the environmental laws (although they may claim otherwise) in the sense that it can prevent entry into the market. The hostile environment in CA to new refineries helps the oil companies drive up prices. The thing the FTCR and Tim Hamilton have completely missed is that the high profits of the oil companies also invite entry into that industry by competitors who want to cash in on those profits, but these potential competitiors are kept out which insulates the oil companies and hurts consumers.
The naivete is further on display when the FTCR sends letters to Bill Lockyer expecting him to do something about it. Lockyer is a politician and as such probably has hopes of making it to the governorship of CA. Does anybody really think Lockyer wants to reduce tax revenues so that if he does become governor he’ll have an even harder time balancing the budget and may have to raise other taxes?
And the solution suggested by the report, regulating gasoline sales, is just silly. We can look at the electricity market in CA and see how well that worked out. Prior to deregulation one of the big reasons CA had high electricity rates was because the state force utilities to purchase electricity from environmentally friendly sources (solar, wind, geothermal, etc.) called Qualifying Facilities or QFs. The cost of this electricity was very high and pushed up the average rate. This lead to a push for deregulation which proponents aregued would lower prices (never mind getting rid of the high priced QFs or renegotiating those contracts). And in the end energy prices in CA are no higher than ever (and ironically for the big industrial/commericial users–i.e. the biggest proponents of dergulation–got the biggest increases). The idea of allowing for more refining capacity and competition to lower prices just doesn’t enter the picture (which was also part of the problem in CA with deregulation in that there was sufficient generation capacity for the most part, but taking one or two generators offline would cause problems and price spikes…pretty much like what we see with gasoline refining).
In short, the problem is that we need more refining capacity. The people at FTCR know this, after all they did write,
“It’s now obvious to most Americans that we have a refinery shortage,” said petroleum consultant Tim Hamilton, who authored a recent report about oil company price gouging for FTCR.
The obvious long terms solution is to not clamp down harder on the refining situation, but to increase the refining capacity and prefereably with new companies to increase competition. Another lesson that anyone who has suffered through an elementary microeconomics course would know.
Thanks to TangoMan for pointing out the press release to me.