May 11, 2008
The Rise in the Price of Oil-Becker
The run-up in the world price of oil during the past several years, and especially the rapid climb during the last few weeks to over $120 per barrel, has fueled predictions that the price will reach $200 a barrel in the rather near future. Such predictions are not based on much analysis, and mainly just extrapolate this sharp upward trend in oil prices into the future. The price of oil in "real" terms (i.e., relative to general prices) will not reach $200 in this time frame without either terrorist or other attacks that destroy major oil-producing facilities, or huge taxes on oil consumption. I try to explain why in the following.
The two previous sharp increases in the world price of oil, in 1973-4 and 1980-81, were due to supply disruptions. The first one was the result of the formation of OPEC that led to output restrictions by members of this cartel, while the later one was due to the Iran-Iraq war that curtailed petroleum production in these two countries. Although the world price of petroleum rose by a lot in all three episodes, worldwide oil production went down in the two earlier ones, while production has risen during the current price boom. The present boom in oil prices has been mainly driven by increases in demand from the rapidly growing developing nations, especially China, India, and Brazil, although output growth in the US and European have added to world demand, and speculation on potential future price increases also contributed to the increased price of oil. To be sure, supply problems in Nigeria, Venezuela, Russia, and other major oil-producing states have contributed to accelerations in the oil price increases at times during the current boom.
Note the contrast between the major causes of the current explosions in oil and food prices. Although the sharply rising prices of different commodities are often lumped together, increases in the prices of corn and other foods have in larger part come from the supply side rather than from demand. The main supply culprits in the market for foods have been the diversion of corn acreage to the production of ethanol, and the increased cost of fertilizers and chemicals used in food production due to the rise in the price of oil (see my discussion of rising food prices on April 13 and 17).
The rapid growth of world oil prices during 1973-74 and 1980-81 contributed in a significant way to the world recessions during those years. Yet even though world oil prices in real terms are now above the prices in 1981, the previous peak in oil prices, and despite the sharp run-up in prices during the past couple of years, the world economy has not (yet!) been pushed into recession. One reason for the difference is that unlike the previous episodes, the current price rises have slowed rather than eliminated the boom in world output. Another difference from the previous episodes is that the share of oil and other energy inputs in GDP is down by a lot in the developed world since 1980, especially in Japan and Europe, but also in the US.
Of course, even with energy's smaller role in the production of output, any rise in oil prices to over $200 a barrel in the next few years would have serious disruptive effects on the world economy. To many persons who have commented on this prospect, such a high oil price seems plausible, given the expected continuation of the rapid growth in the GDP of China, India, Brazil, and other major developing countries. For the evidence is rather strong that the short run response of both the supply of and the demand for oil to price increases is rather small. The small elasticity of both the supply and demand for oil explains why the moderate reductions in world oil supply during the earlier price spikes, and the moderate increase in world demand during the current price boom, produced such large increases in price.
However, the long run response to price increases of both the demand and supply for oil and other energy inputs is considerable. For example, given enough time to adjust, families react to much higher gasoline prices by purchasing cars, such as hybrids and compacts, that use less gasoline per mile driven. They also substitute trains and other public transportation for driving to work and for leisure purposes. High energy prices, and hence the opportunity for large profits, induce entrepreneurs to work more aggressively to find fuel-efficient technologies, including the use of batteries as a replacement for the internal combustion engine.
Clearly, given high enough oil prices, many ways are available to increase the supply of petroleum, Explorations for additional supplies will be extended deeper into oceans and other remote places because the high cost of extracting oil from these sources would be offset by the high energy prices. Usable petroleum is also already being extracted from oil sands and oil shale, and high and rising oil prices will speed up and extend this process. The reserves of tar sands in Canada and Venezuela are huge; indeed, Canada is getting much of its oil production from this source. Oil shale is also abundant in several places, including the United States, and while extraction of petroleum from shale is expensive and complicated, the high prices have induced some countries to start doing this.
Rising prices of oil and other energy inputs will eventually be controlled by new technologies that greatly economize on the use of these inputs. Increased supplies of oil and other energy sources that become profitable to exploit only with prolonged high prices will also push these prices back.
Posted by becker at 09:11 PM | Comments (0) | TrackBack
Why We Should Be Rooting for $200 per Barrel of Oil--Posner
As Becker explains, we cannot predict the future price of oil. But it is unlikely to rise in the foreseeable future to $200 a barrel, especially if we think in inflation-adjusted terms. Oil prices in real terms have fluctuated a great deal. In December 2007 dollars the price of oil was below $20 in 1946, above $100 in 1979, and only about $10 a recently as 1998. High prices affect both demand and supply; the recent price peaks have already reduced demand for gasoline in the United States and increased efforts to discover and exploit new oil fields. The United States has large untapped oil reserves both offshore and in Alaska, and there are many other untapped reserves elsewhere in the world. Supply is responding to the high price of oil and will respond more. If Iraq ever stabilizes, its output of oil will increase. Were the world price of oil to rise to a level close to $200, both demand and (with a lag) supply would respond. Oil trapped in sand and shale--a potentially very large supply--would become economical. In the longer run, very high oil prices will further stimulate the development of alternative fuels.
Major political or natural catastrophes could of course alter the picture. Middle eastern oil supplies are vulnerable to the ever-present threat of war in that region, and the oil industries of Venezuela, Nigeria, and possibly even Saudi Arabia are vulnerable to political unrest, civil war, or terrorism.
I would like to see the price of oil rise to $200, despite the worldwide recession that would probably result, provided that it rises as a result of heavy taxes on oil or (better) carbon emissions. The taxes would jump start the development of clean fuels, and the financial impact on consumers could be buffered by returning a portion of the tax revenues in the form of income tax credits. That would not reduce the effect of the taxes on the demand for oil or the incentives to develop alternative fuels, because the marginal cost (the production and distribution cost plus the tax) of oil to consumers would not be affected. Higher oil prices are necessary to check global warming, reduce traffic congestion, and reduce dependence on foreign oil, so much of which is produced by countries that are either unstable or hostile to the United States. Heavy taxes on oil would reduce not only the amount of oil we import but also the revenue per barrel of the oil exporting nations, so there would be a double negative effect on those countries' oil revenues: they would sell less oil and earn less per unit sold. The reason for the latter effect is the upward-sloping supply curve for oil. Suppose the first million barrels of oil can be produced at a cost of $1 per barrel and the second million at $2 per barrel. If total demand is one million barrels, the suppliers break even: they have revenues of $1 million and costs of $1 million. If total demand is two million barrels, the suppliers have revenues of $4 million (because the price of all barrels is determined by the price that the marginal purchaser is willing to pay) but costs of only $3 million ($1 million for the first million barrels, $2 million of the second). The lower the price of oil received by the oil producers (that is, the price net of tax), the lower their net income.
Unfortunately I cannot see a confluence of political forces that would make heavy taxes on oil feasible. We seem to be experiencing a democratic failure, in which long-term problems simply cannot be addressed.
Posted by Richard Posner at 09:04 PM | Comments (0) | TrackBack
May 04, 2008
The Outlandish Farm Subsidies--Posner
The President has expressed dissatisfaction with the proposed Farm Bill wending its way through Congress. He wants farmers whose annual incomes exceed $200,000 to be denied subsidies; the present cutoff is $2.6 million and Congress will not go below $950,000. The President's concern with farm subsidies cannot be taken very seriously, since in 2002 the Republican Congress with Administration connivance greatly increased these subsidies and at the same time repealed some of the modest reforms that the Clinton Administration had introduced in 1996. The Administration's current proposals would, if enacted, be a step in the right direction, but they will not be enacted, and, judging from the 2002 legislation, they are intended I suspect merely to embarrass the Democratic Congress.
The deregulation movement passed agriculture by, leaving in place a series of government programs that lack any economic justification and at the same time are regressive. They should offend liberals on the latter score and conservatives on the former; their firm entrenchment in American public policy illustrates the limitations of the American democratic system. A million farmers receive subsidies in a variety of forms (direct crop subsidies, R&D, crop insurance, federal loans, ethanol tariffs, export subsidies, emergency relief, the food-stamp program, and more), which will cost in the aggregate, under the pending Farm Bill, some $50 billion a year, or $50,000 per farmer on average. Farm subsidies account for about a sixth of total farm revenues. So, not surprisingly, the income of the average farmer is actually above the average of all American incomes, and anyway 74 percent of the subsidies go to the 10 percent largest farm enterprises. The subsidies are regressive, especially during a recession coinciding with worldwide food shortages (i.e., high prices).
There is no justification for the Farm Bill in terms of social welfare. The agriculture industry does not exhibit the symptoms, such as large fixed costs, that make unregulated competition problematic in some industries, such as the airline industry, about which Becker and I blogged recently. It is true that crops are vulnerable to disease, drought, floods, and other natural disasters, but the global insurance industry insures against such disasters, and in addition large agricultural enterprises can reduce the risk of such disasters by diversifying crops and by owning farm land in different parts of the nation and the world. If a farm enterprise grows soybeans in different regions, a soybean blight in one region, by reducing the supply of soybeans, will increase the price of soybeans, so the enterprise will be hedged, at least partially, against the risk of disaster. Supply fluctuations due to natural disaster create instability in farm prices, but farmers can hedge against such instability by purchasing future or forward contracts. There is no "market failure" problem that would justify regulating the farm industry. All the subsidies should be repealed.
This of course will not happen, and that is a lesson in the limitations of democracy, at least as practiced in the United States at this time, though I doubt that it is peculiarities of American democracy that explain the farm programs, for their European counterparts are far more generous. The small number of American farmers is, paradoxically, a factor that facilitates their obtaining transfer payments from taxpayers. They are so few that they can organize effectively, and being few the average benefit they derive (the $50,000 a year) creates a strong incentive to contribute time and money to securing the subsidies. The free-rider problem that plagues collective action is minimized when the benefit to the individual member of the collective group is great. Then too many of the members of the farm community and hence recipients of the subsidies are wealthy, and the wealthy have great influence in Congress as a result of the lack of effective limitations on private financing of congressional campaigns and on lobbying generally. In addition, the allocation of two senators to each state regardless of population enhances the political power of sparsely populated states, which tend to be disproportionately agricultural. The key role of Iowa in the presidential electoral process is a further barrier to the abolition of farm subsidies, and the final factor is the alliance of urban with farm interests in support of the food-stamp program, itself inferior to a negative income tax, which would give the poor money but allow them to make their own consumption choices.
A puzzle about the farm programs is the heavy emphasis on money subsidies, since by reducing the cost of farming they encourage greater output, which results in lower prices for farm products, thus offsetting some, perhaps much, of the effect of the subsidies. (The lower prices are not a social benefit, because as the result of subsidization they are below cost.) Acreage restrictions, which used to be the core of federal farm policy, and which correspond to the type of entry-limiting regulations imposed on airlines, railroads, trucking, pipelines, long-distance telecommunications, banking, and the wholesale sale of electricity, before the deregulation movement, are more efficient at raising farmers’ incomes by reducing output, in effect cartelizing agriculture. Those restrictions have been reduced, but between them and export subsidies (which reduce the supply of agricultural products to American consumers) farm prices in America are higher than they would be without the farm programs, and this contributes to the regressive effects of the programs.
Posted by Richard Posner at 08:20 PM | Comments (33) | TrackBack
Farm Subsidies and Farm Taxes-Becker
Posner presents evidence on the sizable subsidies received by American farmers from the federal government of the United States. However, the US is not unique, for every rich country including France, Germany, Great Britain, and Japan, heavily subsidizes their farmers, no matter how small the agricultural sectors. In fact, some of these other countries subsidize farmers more generously than even the United States. On the surface, this universal tendency for rich countries to subsidize farming, no matter how different are the details of their political systems, is a paradox. For since only a small fraction of the populations of these countries work in agriculture, farmers cannot contribute much to any majority voting coalition.
Add to this paradox that pretty much every developing country, no matter whether they have democratic or totalitarian political systems, rather heavily tax farmers in order to subsidize their urban populations. Taxing of farmers is as true of India as of China, Mexico as well as Argentina, Egypt as well as South Africa, and similarly for the other poorer nations. In all these countries, farmers are a significant fraction of their populations, and they form a majority in many, such as India and China.
This different treatment of farmers in rich and poorer nations is dramatically seen in the causes of and the responses to the recent worldwide explosion of food prices. American and European subsides to biofuels are an important factor behind the rise in food prices, for these subsidies directly raised the price of corn to consumers, and indirectly raised the prices of other grains (see our recent discussion on April 13 and 17 of the rise in food prices). Riots broke out in many cities around the world in protest against the increases in the prices of bread and other food stables. To quell these riots and other urban unrest, many countries restricted their exports of agricultural goods in order to lower the prices and increase the supply of these goods to their urban citizens. The effect of these export restrictions was to lower the incomes of the farmers in these countries since they were prevented from selling some of their produce on the world market where prices are higher.
This response to rising food prices by the governments of poorer nations is not explained by any concern about fighting poverty in these nations. The fact is that farmers in developing countries are much poorer on average than are their city residents, which explains the continuing migration from the rural areas to cities in these countries. So by putting restrictions on the exports of farm goods, developing countries are not only making their economies less efficient, but also they are adding to the overall incidence of poverty among their populations. The gap between the incomes of rural and urban families is much smaller in developed countries that subsidize rather than tax farmers. Indeed, with the high prices for cereals and other foods during the past couple of years, average farm incomes are often above those of city residents.
I believe that the explanation for the very opposite treatment of farmers in developing and developed countries is interest group competition (see my "A Theory of Competition Among Pressure Groups for Political Influence", The Quarterly Journal of Economics (Aug., 1983), pp. 371-400. This analysis shows that small groups, like farmers in rich countries, often have much greater political clout than large groups, like farmers in poorer countries. The reason is that even large per capita subsidies to small groups, such as farmers in the US, impose rather little cost (i.e., taxes) on each member of the large groups, like urban and suburban residents of the US. As a result, these large groups do not fight very hard politically against the small per capita taxes used to subsidize farmers.
By contrast, a large subsidy to farmers in developing countries would require imposing high per capita taxes on their relatively small urban populations since farmers are a rather large proportion of the total population in these countries. Instead, the same political pressures as in developed countries lead poorer countries, regardless of the nature of their political systems, to subsidize the smaller urban populations at the expense of the larger farm populations.
Hence a common approach to the political process based on interest group pressures can explain both the taxing of poor farmers in developing nations, and the subsidies to well off farmers in richer nations.
Posted by becker at 07:18 PM | Comments (25) | TrackBack
