Dean,

If American refineries were producing gas at capacity, wouldn't we be seeing gas shortages, unless their production is exceeding demand and being stored somewhere (perhaps going to the strategic petroleum reserve?)?

I don't know much about the oil/gas market. Is the U.S. supply limited to the output of U.S. refineries? If not, when you say "refineries running flat out" are you referring to all refineries that are or could supply the U.S. market?

thanks

Brooks,

there wouldn't be shortages, the price would rise as much as necessary to clear the market. We have seen sharply higher gas prices.

Is there a way to independently verify that refineries are running "flat out?" Normally, I would take the oil companies at their word but I'm feeling cynical lately.

I thought refinery utilization was lower of late than it has been for awhile, but that could be all due to maintenance. however, almost any purposeful move to take less profitable capacity offline would have to be billed as maintenance or would be inviting political wrath.

Dean,

thanks, but I'm unclear. When you say "there wouldn't be shortages, the price would rise as much as necessary to clear the market", are you saying that the price has risen enough that people are reducing their consumption (in response to the higher prices) enough to bring demand down to that fixed level of supply? That seems odd to me, unless I'm just not getting it, because I don't see demand for gas in the U.S. as that price-elastic. Wouldn't an implication of what you're saying be that if refinery capacity were, say, cut in half, there would be no shortages because prices would rise so high that Americans would only WANT to consume HALF of what they consume today (i.e., demand would be cut in half)? On a theoretical level, I can see something like that happening (for any product) -- in fact, I'd expect it, assuming a free market -- but for some reason it seems implausible to me in reality. And why did we have shortages in the 1970s? Were there price controls? Or did the oil companies not increase prices as much as they could have?

Something doesn't seem to fit (again, unless I'm just not getting it, and again, I don't know much about this industry/market).

Dean,

Also, weren't the refineries at capacity long before gas reached it's current price? If they were at capacity at say $2.50 a gallon (retail), that the amount they produced equalled the amount that was consumed (about as fast as they could produce it), so supply equalled demand at $2.50, and now they are still producing the same amount and the same amount is being consumed at the same pace at $3.30 a gallon, then demand has not shrunk in response to the price increase, right? People are still consuming as much as is being produced (right?). If they are really operating at capacity and have been for a while now, then demand seems quite price-inelastic as far as I can tell, if consumption was the same at either price. Am I missing something?

Brooks,

i'm not sure what you're missing. demand is inelastic, the price has risen a great deal. This all seems to fit pretty well, so I'm not sure what you see as out of place.

Look at the Valero, Tesoro refiners.
They are running at much less than capacity and are not trying to hide it. This driving season is expected to be less than last years and demand for gasoline is lower. Also, the crack spread (oil - gas) is very low and giving the refiners practically a zero percent profit margin.

What this argument implies, of course, is that the converse might well also be true: increase gas taxes, and the price at the pump wouldn't be in a position to rise by more than a small fraction of the increase, if at all.

Dean,

Well, going back to where I started, you said that if they really are producing at capacity and supply is, therefore, fixed, the price is set by the demand side. I take that to mean you are saying that the price reflects what people are willing to pay for that quantity of supply, and that if the tax is removed, the price will not decrease, but rather stay the same, and the only change will be that the amount of the tax will go instead to the oil companies.

But if demand is fairly inelastic, then the price is NOT a reflection of how much people are willing to pay for that quantity of output. People would demand about the same quantity at a higher price. Which means that, if suppliers are at capacity, the equilibrium price is higher than the current price. Suppliers could charge a higher price and still sell the same quantity (an individual supplier that raised its price would not lose quantity to a competitor, because the competitor is at capacity, too, at least in the short run unless/until capacity is added -- a major investment).

So demand is apparently not determining the current price (consumers would demand the same amount at a higher price), and I assume neither is supply per se (suppliers would supply the same amount at a lower price), so what is? Why aren't the oil companies raising prices even HIGHER, indeed to the point at which some substantial price-elasticity does actually emerge? My guess is that they are concerned about substitutes -- alternative energy development and supply, as well as a political/regulatory backlash, and that's why they don't raise prices as much as they could without reducing short-term demand.

So going back to your central premise -- that if the tax is removed, the price will stay the same because the oil companies will just charge more -- I don't see why that necessarily follows. What is so special about the current price? Even with the tax they could and would charge more if they saw it in their long-term interest to do so. And if P.R./political concerns are what are keeping them from raising prices as much as they could, it seems noteworthy that their main talking point in their defense on the P.R./political front is that their margins as a % of sales are not out of line with many other industries, something that would change if they increased their prices without any increase in their costs (just in response to the tax holiday).

So why do you presume that if the tax were removed, the price would necessarily stay the same, with the oil companies just adding the tax amount to their margins?

Brooks,

you seem to be confusing "inelastic" with the concept of a vertical demand curve in which demand has zero elasticity.

Inelastic demand simply means that the the percentage change in demand in response to a change in price is less than the percentage change in price. In other words, if the price rises by 50 percent, then demand will fall by less than 50 percent. Most research on the short-run elasticity of demand for gas puts it in the range of 10-15 percent (this is very old -- some more recent research may show something different). This does not allow suppliers to set any price they want.

Dean:
The comment doesn't make sense. The gasoline tax is a SALES tax, and thus has no direct impact on Exxon. It lowers the price to the consumer, thus theoretically increasing demand and consumption - which is why greens are peeved.

Dean,

I said as far as I know, demand for oil in the U.S. is "quite inelastic" (I also said "fairly inelastic"), not perfectly inelastic. So I wasn't implying a completely vertical demand curve, but rather a very steep one within the normal range, and one which I suspect -- and which I suspect the oil companies suspect -- would become less vertical (i.e., less inelastic) if prices rose to a much greater degree and reached above a certain point, due to consumers demanding less at a MUCH higher price as well as increasing supply and competitiveness of energy substitutes, which I said was likely part of why the oil companies are not increasing prices as much as the market would bear (meaning as much as they could without reducing the quantity they'd be able to sell, assuming they are all producing at capacity).

So my question still stands. Why do you presume that if the tax were removed, the price would necessarily stay the same (ceteris paribus)? What is so special about the current price, if my sense is correct that the current price is NOT set by demand (i.e., consumers would demand all that suppliers can currently supply even at a higher price), and the oil companies are keeping the price artificially low (vs. what they could charge and still sell the same quantity)?

If suppliers are indeed producing at capacity, and if the price per gallon were to rise, say 20 cents from its current price, I'm assuming that demand would not decrease to the extent that suppliers would no longer be able to sell all they can produce. (1) Do you agree? If so, that means that they could raise the price even with the tax in place and sell just as much, increasing their profits. In fact, if they are at capacity, I suspect that the price could go up much more than that before demand would decrease so much that demand would fall below industry capacity. (2) Do you agree? If so, then demand is not setting the price, but rather self-regulation by the oil companies based on some longer-term interest (avoiding political problems such as windfall profits tax or price controls, and reducing the threat from substitutes). And again, their main defense on the political front is that their margins as a percent of sales are not greater than those of many other industries, and their margins would grow if they used a tax holiday as an opportunity to increase margins, per your premise.

"Also, the crack spread (oil - gas) is very low and giving the refiners practically a zero percent profit margin."

If this is true, why don't the refineries cut back production, raising the price to consumers and dropping the price they pay to suppliers? Does this indicate that they are not running at capacity?

Brooks,

No, I don't agree. By definition, if demand is not perfectly inelastic, then demand will fall if the price of gas rises by 20 cents. Therefore, the oil companies would not be selling all they could produce.

If domestic demand exceeds domestic supply of gasoline, then the oil companies will import gasoline from other markets to meet the demand, at the higher price, as they did after hurricanes Katrina and Rita in 2005.

Dean,

Re: "No, I don't agree. By definition, if demand is not perfectly inelastic, then demand will fall if the price of gas rises by 20 cents. Therefore, the oil companies would not be selling all they could produce."

Again, that presumes that the current price reflects a market equilibrium. I'm saying that such an assumption seems implausible. After all, at what point did the refineries hit capacity (assuming they are indeed, at capacity), only when gas rose to the current price? I think they were at capacity long before the price rose to its current level -- right? If they were at capacity when the price was 20 cents lower than it is today (or 30 cents lower, or 50, or more), than the fact that they are still at capacity (selling all they can produce) refutes your premise, does it not?

The current average price per gallon nationally is $3.39. If what you are saying is/were valid, then if the price were $3.19, you'd say that if the price were to go up to $3.39, the refineries would no longer be able to sell all they can produce. Well, the price IS $3.39 and they ARE selling all they can produce (assuming they are indeed at capacity).

Brooks -

I'm no economist, but it seems that what Dean is saying is that if the oil companies are getting $3.19 per gallon, then with a $.20 tax the price is $3.39. If the tax is removed, then the oil companies can raise their price to $3.39 and the consumer would be none the wiser.

gnat,

I appreciate your attempt to help, but you are missing my point, which is that, if the refineries are at capacity, the price does not reflect a market equilibrium based on demand, as Dean is assuming, so there's no reason (at least none that he has provided) to think that the price would remain at $3.39 if a 20 cent tax were removed.

As I stated above, if they were at capacity back when the price was $3.19 per gallon, then per Dean's logic, we would expect them to be below capacity now. But they are NOT below capacity now, thus refuting Dean's point. I'm awaiting Dean's response to this example.

Something other than market forces seems to be keeping the price no higher than it is today. I've provided reasons to think the oil companies are keeping the price from rising higher (to protect their long-term interests), if they are indeed at capacity.

By the way, I don't like McCain's idea. If we must provide additional stimulus (a debatable proposition), the last thing I'd want to do is make gas cheaper, assuming that's what removing the tax would do. Higher gas prices are a long-term market force contributing the development, production and competitiveness of alternative fuels that contribute less to climate change (NOT including corn ethanol) and which make us less dependent on oil (which could enable us to reduce our Defense budget and avoid some wars), and higher oil/gas prices promote conservation and greater fuel-efficiency over time.

Also, I think raising revenue to start mitigating our long-term fiscal imbalance is a higher priority than short-term (and dubious) attempts to manage economic cycles via fiscal policy. And a Pigovian (Pigouvian) tax like the one on gas is one of the best ways to raise revenue.

Brooks -

I guess I don't understand why you're assuming that the price isn't rising. It's been rising a few cents/gal every couple of weeks (give or take) where I live.

As Curt mentioned above, recent forecasts of gasoline consumption for the summer season predict a drop for 2008 compared to 2007. This is a first for the American motorist, and indicates that we are entering a steeper portion of the demand curve; that is, the slowing consumption reflects an increasing elasticity.

"Old" research may well have pegged fuel price elasticity in the range of -0.1 to -0.15, but that research would necessarily have been conducted (read: "those observations taken and those conclusions estimated") at a lower, less steep portion of the demand curve. The government uses a short-run user-price (including travel-time costs and other operating costs in addition to fuel) elasticity of -0.4 to predict future traffic demand.

To place this in the perspective of Dean's original post, this means that the demand side is sending a signal that it is ready to reduce demand in the face of higher prices. It would be pure speculation to predict the effect on demand of a suspension of the federal fuel tax coupled with an equal and simultaneous increase in the fuel price charged by the oil companies. One might predict that demand would remain unchanged, but that would seem to require automatons for consumers. I think it more likely that consumers would expect the price to drop and to pretty much stay there, amounting to an effective shift of the demand curve. The more likely scenario, should the tax be suspended (which is to say abolished), is that the oil companies would raise their price slowly, matching price increases to various external factors: the additional cost of importing some additional gasoline; continued escalation of crude prices; a convenient pipeline explosion in Iraq. All with the intention of nudging the demand curve further to the right.

gnat,

Re: "I guess I don't understand why you're assuming that the price isn't rising."

Who said the price isn't rising? Not me.

ron cantrell wrote, The gasoline tax is a SALES tax, and thus has no direct impact on Exxon. It lowers the price to the consumer, thus theoretically increasing demand and consumption...

Who remits the tax ultimately is irrelevant to who pays the tax.

A good summary is the Wikipedia article Tax Incidence". To quote from the intro: In economics, tax incidence is the analysis of the effect of a particular tax on the distribution of economic welfare. Tax incidence is said to "fall" upon the group that, at the end of the day, bears the burden of the tax. The key concept is that the tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply.

The article goes on to give this example: The theory of tax incidence has a number of practical results. For example, United States Social Security payroll taxes are paid half by the employee and half by the employer. However, economists think that the worker is bearing almost the entire burden of the tax because the employer passes the tax on in the form of lower wages. The tax incidence falls on the employee.

Another example is land value taxation: because the supply of land is fixed, land rent can be taxed as high as 100%, without the landlords being able to pass any of the tax onto tenants.

Brooks,

I'm afraid I still don't understand your objection. You think the oil companies are lying about being at capacity? that certainly is not impossible, but I'm still not sure if that is what you are saying.

There is nothing obviously inconsistent about the observed price movements and the claim that they are at capacity. Demand will be subject to seasonal fluctuations and generally grows through time, so we would not expect that you would have a constant price even with perfectly even flows. Furthermore, being at capacity does not imply perfectly even flows. Refineries get pulled down for maintenance and deliveries will get delayed due to weather and other factors, so the flow will never be perfectly even. So, I'm not sure what you're objecting to.

Dean,

First, I appreciate your patience with me on this inquiry.

I don't know if the refineries are really at capacity or not, but their not being at capacity would be one explanation for what seems to me not to fit what you're saying.

Let me try a different approach: a hypothetical. Suppose the refineries were already producing at capacity a few years ago, when the price per gallon was HALF what it is today, and were selling all they could produce then, and have been doing so ever since (producing at capacity and selling all they can produce). Back then, when the price was HALF what it is today, you would be saying the same thing that you are saying now: that if they are already producing and selling at capacity, and the price were to go up 20 cents, demand would decrease and they would not longer be able to sell all they could produce. Well, that theory doesn't square with the price DOUBLING and them still being able to sell all they can produce, assuming capacity did not shrink enormously, right? So if my hypothetical actually reflects reality (the price history), which it actually does (IF they really have been at capacity the whole time), then I don't see how it would be valid to say that if they are at capacity and selling all they can, then a 20 cent increase in retail price would reduce demand such that they would no longer be able to sell all they can produce. How could that assertion be valid if it's been consistently proven false (if price has been rising over years, doubling in price, and production has been at capacity the whole time, and they have been able to sell all they can the whole time)?

And the fluctuations in capacity that you mentioned (the fact that operating at capacity throughout this time doesn't imply "perfectly even flows") don't seem significant enough in light of the price DOUBLING to support what you're saying.

Is "capacity" here the classic "can't make any more without hugely disruptive investment" or is it "aren't interested in increasing production because this part of the supply curve is very profitable"?

I just got through this thread, and I'm in the same fog as Brooks. I'd like to take a crack at asking for an explanation from another angle.

What factors are considered in determining (guessing) whether a price hike is likely to cause downward pressure on demand? Recent history has shown that demand is not very sensitive to gasoline price hikes.

And assuming there is currently an equilibrium between supply and demand, what happens if demand goes up 15% (the potential result of everyone going out and buying Hummers in response to the gas tax cut)? Will there be gas shortages then? Or will the oil companies discover some double-secret capacity?

We are not likely to see much increase in refinery capacity because the long term investment is not good. We are only one good round of new CAFE standards away from dropping demand for oil well below capacity. In the late 1970s, the CAFE standards enacted (and fuel switching) reduced oil demand by over 20% creating excess refining capacity. We NEED a conservation policy. Oil Man Bush knows conservation hurts his Buddies' windfall.

http://www.eia.doe.gov/emeu/aer/pdf/pages/sec5_20.pdf

Brooks,

to my knowledge, no one claims that they were producing at capacity when price was at half its current level. The claim is that as prices rose, the refineries responded by ramping up production as much as they could. They have now reached the point where they cannot (by their claim) do anything to substantially increase production in the short-term. In the longer term, they could of course build new capacity by constructing new refineries or expanding existing ones. I have no idea what their plans are along these lines. (btw, if elasticity is 0.15, then this would imply that a doubling of price would lead to a decline in demand of just 15 percent. If demand grew in step with GDP, then baseline demand would grow by about 9 percent over three years, so the doubling in price would only imply a 6 percent fall in demand in this story. If elasticity were 0.1, then demand would be expected to be virtually unchanged in response to a doubling of price over three years.)

Barringer,

in your hummer story, the price of gas would simply rise enough so that the non-hummer crowd couldn't afford it, or decide to stay off the road for their own safety.

There's an awful lot of argument here that is irrelevant to Dean's point. If the price at the pump is $3.00, and $1.00 of that is tax, then the seller gets $2.00. If the tax is instantly removed, then the price at the pump is ideally $2.00. If this decrease in price causes any increase at all in demand, or in other words if demand is not perfectly inelastic, then the price will stabilize above $2.00. All of this increment over $2.00, whatever it is, goes to the sellers.

So, unless demand is perfectly inelastic, reducing taxes has several first-order undesirable effects: increasing demand; decreasing government revenue and increasing deficits; and increasing oil-company profits. Of course it would also have beneficial effects, especially reducing the short-term burden on gas buyers who are unable to reduce their consumption.

Is anyone arguing that oil company profits are too low? Or that gas consumption could not be decreased or increased at all in the short term, such as by carpooling, using public transportation, or just eliminating unneccesary trips? How many cars in rush-hour traffic have more than one occupant?

As bakho points out, oil-product demand is definitely elastic over the medium-long term. Crude price in real dollars is now about as high as it was in 1980, but the economic impact is much less because usage per capita is less.

Why not change the supply curve, instead?

Let's remember that a new refinery has not been built in this country in the last 29 years due largely to the envionmental activists while the demand for gasoline products has increase exponentially during that time. Add that to the requirement of mandated blends for each state for each season makes for a restricted supply.

Why not have some compromise and build some refineries. The clean technology should be much much better.

We need the gas.

Nice discussion. In an update to my EconoSpeak post with hat tip to Greg Mankiw, I link to a couple of other economist disucssions in the same vein. But for some high comedy - check out my Angrybear review of the McCain interview on Kudlow and Company. Even Kudlow sort of gets this incidence issue and he tried to explain it to McCain. McCain still didn't get it. Is McCain really this ignorant of economics?

Dean:

Now come on you know better than to say something this silly and then assume it is true without doing some fact checking (especially if it is likely to be in the best interest of the messenger to lie)...

"According to the oil industry, they have their refineries running flat out, producing all the gas they can."

Go over to the API's website. They have weekely data. The last time capacity utilization was as low as it is today in the month of April......

1991.

Would anybody like to comment on the contribution of commodities speculation to this whole scenario? My impression is that the crude oil and refined products markets are highly speculative and prices, at least over the short term, can be fairly disconnected from actual supply and demand.

Dean,

Re: "to my knowledge, no one claims that they were producing at capacity when price was at half its current level."

First, please answer my hypothetical rather than just disputing the premise. I'll repeat it here:

Suppose the refineries were already producing at capacity a few years ago, when the price per gallon was HALF what it is today, and were selling all they could produce then, and have been doing so ever since (producing at capacity and selling all they can produce). Back then, when the price was HALF what it is today, you would be saying the same thing that you are saying now: that if they are already producing and selling at capacity, and the price were to go up 20 cents, demand would decrease and they would not longer be able to sell all they could produce. Well, that theory wouldn't square with the price DOUBLING and them still being able to sell all they can produce, assuming capacity did not shrink enormously, right?

(1) Please answer the above as a HYPOTHETICAL.

Now, my hypothetical above went further than it had to to make my point. I went back a few years to the point at which the price was HALF of what it is today.

So let me also try a fact-based approach. I have been hearing for at least a year that the U.S. refineries have been producing at capacity, and they have been selling all they can produce. Today the price is $3.39. In August through October of 2007 (just eye-balling the chart http://tonto.eia.doe.gov/oog/info/gdu/gasdiesel.asp ) it was at about $2.80. You wrote above that "By definition, if demand is not perfectly inelastic, then demand will fall if the price of gas rises by 20 cents. Therefore, the oil companies would not be selling all they could produce." Well, you would have said the same thing back in August - October of 2007 if the refineries were indeed operating at capacity at that time. You would have predicted that if the price were to rise to $3.39, demand would fall and they would no longer be able to sell all they could produce. Well, they ARE.

(2) Doesn't that refute your assertion, unless you are claiming that they were not really at capacity at that time?

As a note, I'm assuming that U.S. refineries sell all or almost all of what they produce to the U.S. market and that all or almost all of what is supplied to the U.S. market is from U.S. refineries.

I'm also assuming that fluctuations in inventory levels along the distribution chain (and in consumer/end-user inventories) don't significantly change the picture, so production, sales, and consumption are all roughly equal over time.

Today's exchanges are most interesting. Although I am not an economist, I do have a few thoughts.

First, my understanding is that we import gasoline refined elsewhere. So not all gasoline entering the domestic market is actually refined here in the U.S. While our refineries may be operating at capacity some supply surge may result from imported gasoline.

Second, I doubt that any demand curve truly is linear. While gasoline consumption my may have a steep demand-price curve in a price range of perhaps $0.75 to say $4.75 per gallon, I suspect that there is some price at which the demand- price curve would bend further away from a vertical, inelastic demand curve than what we have experienced to date.

Third, demand-price elasticity seems to be related to the availability of substitute goods and services. The sad truth is that when we are purchasing gasoline we are really purchasing a transportation service of which gasoline cost is an increasing, but still relatively modest, portion of the total cost. In so many localities, those who wish to commute to work and to continue their employment have no substitute for their automobile. Although gas price is increasing, it remains at a modest percentage of the total direct consumer (not societal) cost of automotive transportation (my guess is 20% or less).

The lesson that I take from this discussion is that the gas price / gas tax issue presented here is that we are talking about tinkering at the margin in a societal sense. Eliminating the gas tax will have little, if any, measurable effect on the price that consumers are willing to pay or the amount of gas that consumers will buy. Consequently, Exxon and other will quietly and rather quickly raise their prices to absorb any tax reduction.

If we wanted to know more about price-demand elasticity in the gasoline market we would have to look for those local gasoline markets (if any exist domestically) in which realistic trasportation substitutes are available. We could tell from the actual utilization of the capacity of refineries serving those local markets just how much of the gasoline is consumed locally and how much is transported to other localities. We would also be able to study the price of gasoline in those local markets in comparison to the total domestic market.

Until we actally have such data we are reasoning from a strong point of ignorance as to the relationship of demand and price in the gasoline market.

Brooks,

there are large seasonal fluctuations in gasoline demand and production.

Something I don't understand here - isn't a perfectly inelastic demand curve horizontal, not vertical? Was that just a typo?

Brooks, I think what Dean is trying to say here is that the price increase in the last six months is due to the actual demand curve moving. For example, you'd be willing to buy more gasoline at a given price in summer when you want to drive on the weekends to take your family out, than in the winter when you're only driving to work and the grocery store.

Dean,

I almost decided to address seasonality in my previous comment in anticipation that you might point to it.

Seasonality does not seem sufficient to explain or support your assertion. Take a look at the chart to which I linked previously, and here again. I could have chosen ANY point over the last two years, including the same season exactly one year ago or exactly two years ago, when the price was under $3.00 (vs. $3.39 today) and the point and question would be the same. Again, unless you are saying that only just NOW, at $3.39, are at capacity, and in past months and years they were NOT really at capacity, your point doesn't seem to hold water. If they were indeed at capacity throughout the past year or the past two years, then you would have said all along that if the price were to go up 20 cents -- let's say adjusted for seasonality -- then they would no longer be able to sell all they could produce, assuming no MAJOR reductions in capacity between the points in time in question (whatever pair of points in time were chosen). But you'd be wrong if they were indeed at capacity throughout that period as the price rose, and they were selling all they could produce.

(1) Doesn't the above refute your assertion?

(2) You still haven't answered my hypothetical question above. I hope you will.

Of course, I may just have my axes backward - I was assuming price is on the horizontal axis and quantity on the vertical.

I forgot to provide again that link to the gas prices chart : http://tonto.eia.doe.gov/oog/info/gdu/gasdiesel.asp

Dean,

As follow-up to my questions #1 and #2 above, if I can ask a third question, essentiall the same question but from a different angle:

(3) If the refineries are at capacity now and selling all they can produce, and if the price of oil rises further over the next several months such that the retail price of gas rises 20 cents -- even adjusted for seasonality -- are you saying that "by definition" (as you put it) they will no longer be able to sell all they can produce?

This question is not intended as a substitute for the other two questions at http://www.prospect.org/csnc/blogs/beat_the_press_archive?month=04&year=2008&base_name=mccain_proposes_special_summer&43#comment-6173386 (see also chart at http://tonto.eia.doe.gov/oog/info/gdu/gasdiesel.asp for reference ). I hope you'll answer all three questions.

Is gasoline priced by supply/demand factors or is it cost plus a percentage like most things we buy.

Brooks, it seems to me you're assuming that consumption has been flat over the past few years. It hasn't. Look at the EIA data for "Product Supplied" and you'll see the growth.

Brooks,

sorry, I am really at a loss to understand what you see as inconsistent. Prices are up 15-20 percent from last year. Let's assume a baseline increase in demand of 2-3 percent and that supply is pretty much fixed. What is inconsistent in this story?

BillCinSC,

First, while you are correct that many, perhaps most products we buy are priced based on cost plus some (often arbitrary) percentage, as a management consulting serving small to mid-sized businesses, I advise my clients to take a more sophisticated approach for better financial results. They should consider the trade-off between price changes and sales volume, and impact on profitability, ROI, etc., as well as strategic and other broader and longer-term considerations (e.g., customer relationships/development, brand/company image, impact on sales and profitability of other products, etc., etc.)

But "cost plus" is common because it is simply to apply and because many companies assume (rightly) that their competitors will price that way, and they want their prices to be at a certain level vs. competitors, given whatever they assume about relative cost structure vs. those competitors, or if they just assume it's about equal for a comparable product.

But my clients are not in commodity markets and I don't know much about commodity markets (oligopolistic or otherwise). I assume that in commodity markets, if a free market is operating and if suppliers are not deliberately keeping price below the price that would maximize their short-term profit (which the oil companies may be doing to avoid a political backlash and to slow development of substitutes), price is set by supply/demand, but that, if the industry is not producing at capacity and there is no collusion or price coordination via signalling, competition among suppliers keeps prices, in effect, at some particular level above cost that provides an acceptable ROI for suppliers. In other words, assuming capacity is not an issue, the forces of supply & demand combined with competition among suppliers force suppliers into a cost plus approach to pricing.

Please note: I'm not an economist and as I noted above, I don't work in commodities and don't know much about commodity markets. The above is just my best guess. Perhaps someone can confirm/correct/augment/refine what I've said.

Dean,

Can you please just answer my three questions. If you would answer them directly, perhaps either I could see what you're saying or vice-versa. That's why I asked them. And I think they are fairly clear, at least to someone at your level.

PLEASE answer all three questions if you don't mind. I really would appreciate it, and perhaps others would as well.

If you won't answer #1 and #2, at least answer #3, which I'll paste again here:

Again, you wrote: "By definition, if demand is not perfectly inelastic, then demand will fall if the price of gas rises by 20 cents. Therefore, the oil companies would not be selling all they could produce."

(3) If the refineries are at capacity now and selling all they can produce, and if the price of oil rises further over the next several months (or years) such that the retail price of gas (in real terms) rises 20 cents -- even adjusted for seasonality -- are you saying that "by definition" (as you put it) they will no longer be able to sell all they can produce (because demand at that higher price will necessarily fall to below the level of production capacity)?

Please at least answer THAT question.

thanks

"What is inconsistent in this story?"

Dean, nothing is wrong with your story. You simply refuse to accept Brooks' tenditious assumptions and biziarro concept of 'ceterus paribus'.

That Brooks is simply niggling can be seen in his post at 6:52 PM where he asked about the 1970's shortages and price controls. A 15 second google search would reveal that, indeed, price controls and rationing were instituted in response to the arab oil embargo following the Yom Kipper war.

So why did he ask the question? I am of the opinion that the answer is rather obvious (cf. Brooks and Social Security).

bobbyp,

That is really uncalled for. Why must you attack me? I'm just trying to discuss something, trying to learn, and perhaps contributing positively to the learning of others. I am not asking these questions in pursuit of any agenda, let alone pursuing some hidden agenda via some devious tactic as you seem to think I am. In fact, I've said above that I think McCain's idea is very bad policy for a number of reasons. So why must you be uncivil?

As a note, I didn't know if price controls were instituted in the 1970s. That's why I asked.

Brooks, how about answering a question. Do any of your questions reflect the fact that the demand for gasoline in the US is not constant and has been steadily growing?

none,

I don't know how to answer your question. How does your information relate to my questions? I'm not asking rhetorically; just please spell it out for me.

If demand for gasoline has been steadily growing, I would think that would mean that either refineries weren't at capacity previously or they have been but capacity has been expanding (or augmented by non-U.S. refineries). This assumes that there was not some huge draw down of inventories.

Please spell out for me what your point is, and how it relates to my questions.

thanks

EUREKA! I agree completely with BobbyP.

For whatever it's worth, it seems to me that for suppliers to have been at capacity over a period of time during which price has risen (say, the last year or two), either capacity has decreased (vertical part of supply curve shifting left and intersecting the demand curve at a higher price), the demand curve has shifted right, or demand has been perfectly inelastic over that price range (moving up the vertical portion of the demand curve), or the price has been below equilibrium and has been able to move up without yet intersecting with the demand curve above (although I would expect that to produce shortages).

As I've stated before, that assumes that inventory level fluctuations don't significantly affect the picture.

I'd welcome anyone's correction/confirmation/refinement/augmentation of the above. I'm just trying to think this through; I'd appreciate any help.

Wish I could show here my hand-drawn charts with supply/demand curves to illustrate my points.

I certainly hope that everyone remembers that even if there is excess capacity in domestic refineries, the demand for crude from China, India, etc. would far exceed any conservation efforts we could mount in the short run.

So even if McCain waved a magic wand and lulled the Congress into passing his proposal, the increase in gas prices this Summer would far exceed the amount of Federal levy.

bailey,

Why do people like you and bobbyp have to turn absolutely everything into some hostile battle? Can't someone try to learn more about some technical aspect of economics without being attacked based on some kind of supposed malicious intent attributed to him baselessly and presumptuously by you?

What is wrong with you? Is it simply some flavor of paranoia? Is it just some petty grudge from a previous encounter? Seriously, what leads someone like you and bobbyp to attack someone who is just asking questions and discussing technical aspects of economics? I find it both fascinating and sad, the latter not because it irritates me (although it often does), but because it represents a big and worsening problem with political discourse in America today. So many people are in knee-jerk attack mode, generally on a partisan basis, even if there is no partisan matter or position being discussed (e.g., if a 20 cent rise in the price of gas would drop demand to below refinery capacity, or if the removal of the gas tax would necessarily NOT cause the price to drop, ceteris paribus).

Can't people just discuss things in a civil way (and even debate in a civil way), share perspectives, hopefully learn from each other, etc., rather than having it turned into a verbal food fight with their integrity and motives attacked? Is that really too much to ask?

As follow-up to my comment above re: civil discourse, I'm not suggesting that it is never appropriate to question someone's integrity or motives, only that it should be done reluctantly and only after very substantial cause to have and express such suspicions.

Oh, and it is almost always better to engage on substance and debate arguments on their merits rather than focusing on someone's supposed lack of integrity or supposed motive, or at least it is better not to ONLY engage in such attacks IN LIEU OF directly addressing the argument.

One thing you need to understand about the oil industry is the effect of conservation and CAFE standards. Big Oil took a BIG hit when oil consumption dropped after 1978. The primary reason that no new US oil refineries were built between 1981 and 2000 is because of excess capacity. Not only were no new refineries built but many existing refineries were closed. This is because the demand was less than 70% of capacity in 1981. The least efficient old and small refineries were closed and capacity expanded at the more efficient refineries. The line about refineries not being built because of environmental laws is Bush and Big Oil hokum. (Yes, they are lying about this, too.)

http://www.eia.doe.gov/emeu/aer/pdf/pages/sec5_20.pdf

A refinery planned today would take several years to come online. There is no guarantee that high prices will set off a new round of CAFE, efficiency and conservation that results in a drop in demand. Building a new refinery today would be risky.

High gas prices cannot be fixed by cutting gasoline taxes. They can only be fixed by conservation and energy alternatives that reduce demand below capacity. After conservation started in a serious way in 1978, demand for oil did not return to 1978 levels until 2000. That is when we started to see gasoline prices increase. We would be wise to demand more fuel efficient vehicles and keep the price of gas artificially high with higher gas taxes to maintain support for CAFE standards and efficient vehicles.

I think that I have to agree with Brooks in this discussion. I’m drawing my supply and demand curves, and feel that the downward shift in the supply function resulting from the summer gas tax holiday should lead to a drop in the gasoline price by most of the federal tax rate of 18.4 cents per gallon. My sense is that the demand curve for gasoline is more inelastic than is indicated in the older study sited by Dr. Baker. Given that the United States does import some small quantities of gasoline (approximately 5 percent of our gasoline supply is currently satisfied by imports), it seems to me that the small increase in the quantity of gasoline demanded by consumers that would be spurred by the temporary suspension of federal taxes could be met by imports. In addition, if the suspension of the federal gasoline tax is only temporary, I don’t think that we would see changes in demand that one might expect to see over the long term. For example, people aren’t likely to trade in their Prius for a Chevy Suburban because of a temporary lowering of gasoline prices.

Motor Gasoline Imports, 1945-2007:
http://tonto.eia.doe.gov/dnav/pet/hist/mgfimus1A.htm

Motor Gasoline Consumption, 1945-2007:
http://tonto.eia.doe.gov/dnav/pet/hist/mgfupus1A.htm

Predictions are for gas to hit $4 per gallon in the Midwest this summer. WTF difference is 18 cents going to make? Gasoline prices go up and down by more than that every week. If there were surplus and excess gas to sell, then yes, a drop in gas tax would probably drop the price some. However, in the current climate, price is being set to meet demand. Dropping out the taxes will not drop price at the pump.

Looks like I'm not going to get answers to my questions (#1, #2, or even just #3) from Dean. Kind of frustrating.

Brooks,

You are making some odd assumption that demand for gasoline is steady throughout the year. It isn't.

Demand for gasoline is seasonal. It always goes up in the summer when people drive on vacations or to their weekend home.

Plus refiners have to change their blends in the summer to meet environmental standards. Plus they have to produce other oil products (like home heating). Plus, there are problems with storing refined gasoline that discourages stockpiling.

So if refiners are at capacity now, when summer demand goes up (this is the point you seem to be missing), the price will go up until demand starts to drop below supply. That price where demand drops is the same whether 20 cents goes to fix the roads or goes to Exxon. This is nothing more complicated than Econ 101.

bakho,

First, thanks for your comment. I appreciate your help as I try to sort this out.

I am making no such assumption of a lack of seasonality. In fact, I've acknowledged seasonality.

And more or less what you've said is what I would expect theoretically if indeed they are at capacity and capacity quantity is essentially fixed (i.e., fluctuations negligible), if demand is NOT perfectly inelastic within the relevant price range, and the demand curve shifted right (due to summer lifestyles involving desire to drive more). I would expect the equilibrium price to move up the demand curve until it intersected with the supply curve at the same quantity as before -- AT that quantity, not below it -- at that higher price, because that quantity is fixed if they are at capacity (and IF they are essentially only supplying the U.S. market and if the U.S. market is supplied by only them, and if inventory fluctuations aren't significant). And indeed if the tax were taken out, that ultimate price would be the same as if the tax were there, and just more of it would go to the seller, as Dean and you assert. Similarly, if there were NO shift leftward (up) in the demand curve (e.g., from summer) and the tax were removed, and demand were not perfectly inelastic over the relevant range, I would expect the price to remain unchanged following the removal of the tax (perhaps after a brief adjustment period) for the same reason, with the amount of the tax simply shifting to the seller, again as Dean asserted.

But here's the problem I'm having: Let's say, hypothetically, they were at capacity when gas was $2.50 (adjusted for seasonality or comparing the same season across years or whatever), and now they are at $3.39. Assuming that capacity quantity over this time period is essentially fixed, if your assertion is correct, then unless the demand curve shifted substantially leftward (i.e., a big increase in the desire for gas at any given price), suppliers would no longer be at capacity (in the sense here of selling all they can produce). Do you agree?

Please answer that hypothetical question, and maybe we can take it from there.

Brooks,

I think I have figured it out. We were having the same discussion over here http://angrybear.blogspot.com/2008/04/kudlow-and-mccain-discuss-economics.html

I think what Baker is talking about is a situation where:

1) There is a completely immovable supply, that is a completely vertical supply curve. That's his "full capacity"

2) There is a completely horizontal(inelastic) demand curve. That is no matter what the price is the quantity demanded is the same.

Under these circumstances the oil companies can capture the federal tax relief as profit.

While the current oil market has these characteristics, it takes only a very small change in either the supply or demand side to upset the balance and quickly return the 18 cents to the consumer.

While either the supply or demand side can break down. It is most likely the supply side where this will happen.

Say the supposedly immovable supply/demand is 100 gallons per week at $4 per gallon. Somehow an extra 1 gallon (foreign source, new find, in storage, whatever) enters the supply. It will literally be unable to sell its product..... unless it cuts its price, even 5 cents will do. The remaining supply will have to adapt... until the "excess profit" represented by the federal tax relief is arbitraged away, as you describe.

So you are both right, but Baker is only correct under the highly unlikely theoretical conditions of a laboratory; you are right in the way the real world would work.

sammy,

thanks. I'll go there to check out what's being said.

In the assumption that I've been stating -- roughly fixed capacity over the relevant price range -- I am indeed assuming a vertical supply curve over the relevant price range.

As I've mentioned, one of the possible explanations for what's puzzling me is if demand over the relevant price range actually is perfectly inelastic -- meaning vertical, not horizontal, and possibly that the oil companies have not been charging a high a price as they could without dropping below their capacity (if so I presume it would be to slow the development of substitutes and/or to reduce the threat of government intervention such as a windfall profits tax, price controls, etc.). Such assumptions would explain how they could be at capacity at a lower price, the price could rise, and demand NOT drop below capacity even if capacity quantity has not changed.

BUT, if the oil companies are not charging as high a price as they could, but are rather balancing their short-term profit (ROI) objectives against the longer-term strategic objectives of slowing subsitutes and warding off government action, then there is no reason to presume they would automatically raise the price to compensate fully for the removal of the tax.

Now I'll head over to angrybear.

In your scenario, if supply meets demand at $4.00/ gal, the price will be $4.00 no matter what. The price will be $4.00 whether the 18 cents in question goes to the government to fix the roads or to Exxon. You are trying to make it more complicated than it really is.

Brooks,

"I am indeed assuming a vertical supply curve over the relevant price range."

But Baker is making the additional assumption that it cannot shift.

Hi bakho,

"if supply meets demand at $4.00/ gal, the price will be $4.00 no matter what."

Not if supply or demand changes, which they always do, that's why prices fluctuate.

The price on the supply and demand curves is the same whether or not the entire price goes to BigOil or 18 cents goes to fix the roads. Making the tax go away is not going to magically increase the supply. If an extra gallon is found, it will have the same effect on the price whether or not the tax is in place. The supply and demand curves are unchanged by the tax.

The price of gasoline will be at the intersection of supply and demand, whether or not there is a tax. So either the money goes to fix the roads or goes to Big Oil. Either way the consumer pays.

McCain claims to know nothing about economics and either he is out to prove it or give BigOil a tax break in exchange for a campaign contribution under cover of economic illiteracy.

bakho,

I'll try it this way: if cost of a barrel of oil declines, wouldn't you expect the cost of gasoline at the pump to decline? If so, why?

The Fed tax is built into the cost at the pump also. If it declines, why wouldn't you expect that to be reflected similarly?

If my costs decline by 18 cents/gallon, I can try to keep it. But my competitors, who have also seen the 18 cent cost decline, start undercutting me and taking my sales away....

but you are right about McCain's economic knowledge. I don't think Hillary or Obama are any better, probably worse. The advisors will be key.

In our state, we saw the gas tax stupidity in 04. The Gov (a Dem) suspended the state gas tax and the price at the pump did not change. It is a stupid idea regardless of political party.

Don't assume that refineries are in competition. In many areas, all the gas stations get their product from the same one or two suppliers. If the price at the pump drops, demand increases almost immediately (people top off when the price drops and run on fumes when the price is high). Suppliers will respond by increasing prices. Consumers can only win by reducing demand. This is what we saw in the early 80s after the CAFE standards took full effect.

bakho,

Let me try this way:

I think a helpful way to approach this (for me at least, and I think for others) is to start with a model based on a few assumptions to simplify matters. So let's assume:

1) All suppliers that can supply the relevant market (the U.S. market) were at capacity when gas was at $2.50 per gallon and they are still at capacity at $3.39. They are producing at capacity and selling all they produce.

2) The capacity quantity has not changed over this period and price range. So the supply curve over this price range has been vertical.

3) The demand curve has not shifted leftward during this period. (Gas has not become more desirable at any given price).

4) Seasonality is either adjusted for, doesn't exist, or otherwisde does not significantly affect our supply & demand curves.

How can we explain that the same quantity was sold at $3.39 as at $2.50? Wouldn't it have to mean that over that price range demand is perfectly inelastic -- a vertical demand curve over that price range?

And if that were the case, wouldn't it have to mean that back when the price was $2.50, the suppliers could have been charging a higher price without losing any sales quantity, but for some reason did not charge that price even though that would maximize short-term profit?

bakho (and Dean Baker, you'd be so kind as to respond),

To be clear, I'm not asking you to accept that the assumptions of that simplified model (in my comment above) reflect reality. I'm just asking you to assume them for now, as a starting point for discussion.

If the tax on gasoline declines and the gasoline price declines, then the demand for the oil will increase and the price of the barrel of oil will increase. The winner of the 18 cents is some combination of Government, BigOil and Oil Exporters, NOT the consumer.

Yes, you can give temp relief with a tax cut. You can also cause temp pain with a tax increase. However, the price will quickly return to the intersection of supply and demand. The 18 cent tax is trivial compared to the price swing of over $1 that we will experience. In the meantime, how do we pay to fix the potholes? That 18 cents has to come from some other tax.

CORRECTION:

In my comment above, assumption should read:

3) The demand curve has not shifted RIGHTWARD during this period. (Gas has not become more desirable at any given price).

On further consideration, I think that I have changed my mind, and probably agree with Dr. Baker’s analysis (sorry Brooks). If we are indeed along a vertical portion of the supply curve, the slight downward shift in the supply curve that would result from a temporary suspension of the federal gasoline taxes of 18.4 cents per gallon would lead to no change in the equilibrium price for gasoline. Of course, this assumes that imports of gasoline really aren’t a very significant or viable source of additional supply. But then again, in an era such as we are currently in when daily and weekly gasoline prices fluctuate substantially, 18 cents pretty much seems like noise.

The 'competition' argument is a complete red herring when every supplier is able to sell all the gas it possibly can.

Suppose one supplier does cut its prices. All that happens is, that supplier runs out of supply quicker. Result, shortage, empty pumps and *less* profit.

You never start cutting prices unless forced to by falling sales. Simple.

Oh by the way, the US imports crude oil, not gasoline. I don't think there are systems set up for there to be 1) refineries overseas running well above capacity 2) gasoline tankers going back and forth across the oceans 3) distribution systems to get gas from the ships to the shops.

That was the point of the crucial question: whether the refineries here really are at maximum capacity.

fabian,

Re: "If we are indeed along a vertical portion of the supply curve, the slight downward shift in the supply curve that would result from a temporary suspension of the federal gasoline taxes of 18.4 cents per gallon would lead to no change in the equilibrium price for gasoline."

Why would suspension of the tax shift the supply curve at all? The tax is paid by buyers, not suppliers. The immediate effect of removing the tax would be a lower retail price and movement down ALONG (not a shift of) the DEMAND curve. If supply is fixed and demand is not perfectly inelastic over that price range, that would cause shortages unless the price were, in effect, bid back up to the previous price to move back up along the demand curve back to that fixed supply quantity (the dynamic Dean assumes).

The problem I see with Dean's assertion, though, is that if -- again, IF -- suppliers were at capacity when the price was lower than it is today, and if capacity quantity (supply) has been more or less fixed since then, his theory would anticipate that at today's higher price, demand would be less than that fixed supplier capacity. If that is counterfactual -- if they are still producing at that same capacity and selling all they can produce at today's higher price -- then some assumption of his theory must be wrong, it seems to me. How could it be that supply quantity is fixed (vertical supply curve over the relevant range), demand is not perfectly inelastic over the relevant price range, and the price has moved up very substantially, yet the same quantity is demanded. Only explanation I can think of is a very substantial rightward shift of the demand curve (buyers desiring much more gas at a given price), but I don't see that as part of Dean's argument.

To follow up on my comment above, here are the possibile explanations I see:

- Suppliers (all actual and potential suppliers to the U.S. market) are not really at capacity (or at least weren't at lower prices)

- Capacity has not really been essentially fixed, but has substantially contracted (vertical portion of supply curve shifting LEFT)

- Demand curve shifting substantially rightward (buyers demanding more gas at any given price over the relevant price range)

- Demand over the relevant range being perfectly inelastic (vertical curve) combined with suppliers previously pricing below what they could have charged without losing sales quantity, thus not maximizing short-term profit (which the oil companies could have been doing to slow development/competitiveness of substitute energy technologies and/or to prevent governmental intervention such as windfall profits tax, price controls, etc.). Graphically, this situation would be overlapping vertical supply and demand curves over the relevant price range, with the actual price moving straight up along both curves.

- U.S. refineries are serving other markets, not just the U.S. market, so some of production is (or at least has been) sold elsewhere.

If anyone else has more possible explanations, I'd be interested.

I also hope someone -- particularly Dean Baker, but anyone -- will answer my question.

I'll repeat it here so I can include the correction I made:

So let's assume:

1) All suppliers that can supply the relevant market (the U.S. market) were at capacity when gas was at $2.50 per gallon and they are still at capacity at $3.39. They are producing at capacity and selling all they produce.

2) The capacity quantity has not changed over this period and price range. So the supply curve over this price range has been vertical.

3) The demand curve has not shifted very substantially rightward during this period. (Gas has not become much more desirable at any given price).

4) Seasonality is either adjusted for, doesn't exist, or otherwisde does not significantly affect our supply & demand curves.

How can we explain that the same quantity was sold at $3.39 as at $2.50? Wouldn't it have to mean that over that price range demand is perfectly inelastic -- a vertical demand curve over that price range?

And if that were the case, wouldn't it have to mean that back when the price was $2.50, the suppliers could have been charging a higher price without losing any sales quantity, but for some reason did not charge that price even though that would maximize short-term profit?

The comment two comments up, "Anonymous | April 18, 2008 10:33 AM" was me (forgot to put my name)

Brooks,

The problem here may be the lack of a blackboard. I believe that my assertion about the downward shift of the supply curve is correct. The points along the supply curve should represent the total cost of motor gasoline at each successive quantity, including State and Federal taxes. The current equilibrium is the point where the current supply and demand curves intersect. When you shift a supply curve downward, each point along the supply curve will get shifted down by the same amount. Thus, if the demand curve is crossing the supply curve along that vertical portion, the downward shift in the supply curve for gasoline from a suspension of the federal gasoline tax should not lead to a change in the equilibrium or market price. This is because each point on the vertical portion of the supply curve will get shifted down by the same amount.

I think that you really need to look at McCain’s proposal in isolation from other things. His change would not affect the demand curve for gasoline, which represents the prices that each individual consumer is willing to pay for a unit of gasoline.

Neither the demand nor the supply is entirely constant and that is one reason for the cyclical price fluctuations. There is more demand in the summer. There are changes in supply that are seasonal as some oil is refined for home heating and other products and unavailable for gasoline. There are decreases in supply that have to do with fuel blends and octane.

The price in any season is the price set by the intersection of the supply and demand curves. The gas tax changes neither the supply nor the demand curve under current conditions. The gas tax reallocates a portion of the price (18 cents) to fix the roads instead of the profit stream. The consumer gets nothing by cutting the tax. In fact, the consumer loses because the potholes do not get fixed or the consumer has to pay the full price for the gasoline AND additional taxes to fix the potholes.

fabian,

I still don't see your point regarding a shift in the supply curve.

The supply curve represents what quantities suppliers are willing to supply at various price levels. If supplier costs are lowered, then yes, I'd expect a downard shift in the supply curve, but the tax is not a cost borne by suppliers. It is borne by buyers. So as I say in a previous comment, removal of the tax would represent a movement down along the demand curve, but if supply quantity were fixed (vertical supply curve over that range), if demand were not perfectly inelastic over that range and the suppliers were seeking to maximize short-term profit, the price would end up back at the original price (which is Dean Baker's assertion).

However, IF you had some situation in which a supply curve shifted downward, but the relevant portion of it were vertical, then yes, equilibrium price and quantity would be unchanged because, as you say, the supply curve would still be intersecting the (presumably downward sloping) demand curve at the same point of price and quantity.

You're right about the usefulness of a blackboard. If you (and/or others) happen to be in NYC, I'd be up for sorting this out over pizza and napkins with lots of graphs sketched on 'em.

Also, if anyone knows of a simple way we can each create and share graphs, please advise. All I could do is create Excel spreadsheets and turn them into charts, or just fill in cells to create the impression of curves, and then email as attachments.

bakho,

Two things about your comment seem questionable to me.

First, SEASONAL fluctuations in capacity and in demand wouldn't seem to address how the price could rise substantially -- even comparing apples to apples on season or adjusting for seasonality -- and suppliers could have been at capacity then and still at capacity now, selling all they can produce. A substantial price rise would be expected to cause demand to drop below capacity quantity rather than demand staying at that quantity.

Second, if supply over the relevant time period and price range were NOT more or less fixed (adjusting for seasonality, if you wish), then the supply curve would be upward sloping (or perhaps even horizontal over that range), not vertical. Therefore, a reduction in price due to the removal of the gas tax would cause equilibrium price to move down along the demand curve until it hit the supply curve at a lower price than the price that included the tax. So, in that scenario, it would be incorrect to say that if the tax were removed that the price would stay the same and the foregone tax revenue is simply shifted to the profits of suppliers.

CORRECTION:

My second point above is incorrect. Please disregard. Removing the tax would put price below equilibrium. If the supply curve is NOT vertical over the relevant price range (i.e., essentially fixed supply quantity, adjusted for seasonality if one wishes), then removal of the tax would just temporarily drop the price, but price would move back up to equilibrium, and in that scenario, then yes, the tax revenue would be lost and it would shift to suppliers.

...And even if the supply curve IS vertical over that range, as I've said, the same would happen (price would end up the same), IF demand over that range is NOT perfectly inelastic and if the suppliers are setting price to maximize short-term profit.

But the fact (as far as I can see) that history suggests otherwise is the inspiration for my exploration here. Again, IF suppliers were at capacity at a much lower price (adjusted for seasonality) and they are still at capacity now at a much higher price, and capacity is essentially the same (hasn't contracted sharply), something doesn't fit. I've listed what I think are some possible explanations in a comment above.

Straight lines are only models, not reality. Once demand hits current capacity, a structural barrier for supply is reached. No additional supply could be brought to market without huge upfront investment in new refineries. The cheap oil flows into the refineries first, and then the more expensive oil. New refinery demand would increase the price of crude oil.

Continued rising crude prices and pressures to conserve could work to back demand for gasoline far below supply. This is what happened between 1978 and 1983. As the CAFE standards enacted by Presidents Carter and Ford kicked in, oil consumption DROPPED by over 20%. Utilization dropped from over 90% of capacity to under 70% of capacity. Who is willing to risk building a new refinery in the face of simple political will? Many argue that the will for more efficient cars is there but being blocked by the BigOil president.

The only way to reduce gas prices is to back demand away from supply.

Brooks, the problem with your oft-repeated question is that it literally makes no sense. Your hypotheses are inconsistent. The market price is the intersection of the supply and demand curves. If neither the supply nor demand curve has changed, neither can the market price have changed. If you want to assume that the market price has in fact increased, it must be the case that either the demand curve has shifted so that more is demanded at the same price, or the supply curve has shifted so that less is supplied at a given price, or a combination.

Nivedita,

You haven't paid attention to what I've said. I've laid out the possible explanations that I've thought of. Since you somehow missed them, I'll copy & paste here for your convenience:

- Suppliers (all actual and potential suppliers to the U.S. market) are not really at capacity (or at least weren't at lower prices)

- Capacity has not really been essentially fixed, but has substantially contracted (vertical portion of supply curve shifting LEFT)

- Demand curve shifting substantially rightward (buyers demanding more gas at any given price over the relevant price range)

- Demand over the relevant range being perfectly inelastic (vertical curve) combined with suppliers previously pricing below what they could have charged without losing sales quantity, thus not maximizing short-term profit (which the oil companies could have been doing to slow development/competitiveness of substitute energy technologies and/or to prevent governmental intervention such as windfall profits tax, price controls, etc.). Graphically, this situation would be overlapping vertical supply and demand curves over the relevant price range, with the actual price moving straight up (vertically) along both overlapping curves.

- U.S. refineries are serving other markets, not just the U.S. market, so some of production is (or at least has been) sold elsewhere.

The second to last bullet point above would indeed represent a situation in which price could go up without a shift in either curve. Wish I could show you the graph visually, but you'll just have to sketch it yourself based on my description. Let me know if it makes sense to you now.

Brooks, I'm only saying that your counterfactual hypotheses are inconsistent. If you want to debate reality, we can talk about that too. None of your hypotheses are true in the real world, where demand has increased, supply capacity has increased, neither demand nor supply is perfectly inelastic, and crude prices (the raw material for a refinery) have almost doubled over the period where retail gasoline has gone from 2.50 to 3.40. Obviously the impact of crude prices causes a massive change in the supply curve, as there is no longer any supply at 2.50/gal, which is below even the cost of the raw material, let alone capital costs, operating costs and distribution costs.

Nevedita,

I think you are misunderstanding my approach (or at least not seeing it as useful) and my purpose.

Regarding purpose, Dean has asserted that if the 18 cent per gallon tax were removed, the price would not change, and the effect would simply be that the government would lose that revenue and suppliers would gain it.

I am trying to start with a simplified, hypothetical model and work from there to figure out if that theory is valid, given that IF particular assumptions are made, the theory seems to contradict empirical evidence.

I'm referring to the fact that the price has risen dramatically, yet (at least per what I've heard for a while) the refineries were already operating at capacity back when the price was substantially lower, and as far as I know capacity has not shrunk dramatically if at all. If at capacity X they can sell all they can produce at $3, then why would they have charged only $2.50 if their goal were short-term profit maximization?

One possible explanation could be that they were NOT charging as much as they could (without losing sales quantity) and NOT maximizing short-term profit, but rather charging an artificially low price to serve some other strategic objective (slow development of alternative energies and/or prevent government intervention that could hurt long-term profitability). If that were the case, then removing the tax would not necessarily result in no change in the retail price as Dean asserts, because suppliers would not necessarily increase the price they charge by the amount of that tax. They might not charge more, since, in that scenario, they are already balancing the conflicting objectives of short-term profit maximization with the aforementioned strategic objectives that lead them to limit the price they charge below market equilibrium.

If they were pricing below equilibrium and they were at a fixed capacity and demand were NOT perfectly inelastic, then I would expect shortages. But we don't see shortages, so one possible explanation would be that, in addition to the supply curve being vertical over that price range, the demand curve is also vertical over that range (perfectly inelastic). That could explain how they could have been at capacity X at a lower price, still at capacity X (i.e., still selling the same amount) at the higher price.

Otherwise, it seem to me that the only way that this could occur -- same quantity sold at the higher price -- is if the demand curve shifted VERY substantially to the right (i.e,. gas became a lot more desirable at any given price) over this time period. But removing the tax would NOT shift the demand curve. The immediate effect would just be a price reduction, a shift down ALONG the demand curve. If demand in NOT perfectly inelastic, this would move equilibrium quantity to the right (higher quantity). But if supply is fixed, equilibrium quantity cannot move to the right (cannot increase). Which brings us back to Dean's point, which is that, he asserts, the result would be that price would, in effect, be bid back up to the previous price as suppliers charged more to bring the price back to it's original point, with equilibrium back at supplier capacity.

This is hard to discuss without sketching out graphs. I invite you or anyone in NYC to join me for pizza to discuss sometime. If anyone knows of an easy way to create and share supply/demand graphs digitally, please advise.

Nevedita,

As follow-up to my comment above, just to address one of your points explicitly:

Re: "If neither the supply nor demand curve has changed, neither can the market price have changed."

Not true. You are assuming a free market (no price control), a demand curve that is NOT perfectly inelastic over the relevant range, and profit-maximization by suppliers (i.e., suppliers charging as much as they can to sell a given quantity).

If suppliers are at a fixed capacity and they are pricing below the profit-maximizing price, and if demand is perfectly inelastic over the relevant price range, we would have, over the relevant price range, overlapping vertical supply and demand curves (at the capacity quantity). And since we would have multiple equilibria, price could increase without a change in eqilibrium quantity.

And to put things in a different way, if the demand curve over the relevant price range is NOT perfectly inelastic (i.e., it is downward sloping) and capacity over the relevant price range is fixed (i.e, vertical supply curve over that price range), then IF suppliers were at capacity and then the price increases by a huge amount, either there has been a huge rightward shift in the demand curve (i.e, the product has become MUCH more desirable at any given price) or suppliers are no longer at capacity (selling all they can produce).

But if there has been no huge rightward shift of the demand curve, and if capacity has not substantially changed, and if they were at capacity at the lower price and still at capacity at the higher price, there must be some explanation, and that's what I've been seeking and offering the possible explanations that I see.

Correction:

If demand is highly inelastic -- even if it's not perfectly inelastic -- it would NOT take a HUGE rightward shift in the demand curve for equilibrium quantity to be the same after a huge price increase. A small shift rightward of the demand curve could produce that result. If price elasticity for gas is only 0.1, a small rightward shift in the demand curve could be a realistic explanation for how the same quantity could be demanded at a much higher price.

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