In defense of high profits

by Russ Roberts on October 31, 2005

in Prices

Here is the text of the commentary I did this morning at NPR’s Morning Edition.  You can listen to it here.  At the bottom I’ve added some afterthoughts.

Those Senate hearings on the cause of high gasoline prices should be really brief. Three words. Supply and demand.

When hurricanes destroy refining capacity, pipelines and drilling platforms there’s less gasoline to go around and prices rise.

Everybody knows what’s bad about high prices. Less money for us. More money for the oil industry.

But high prices are good, too. When prices are high, some people will drive less, car pool, buy more energy efficient cars allowing the people who really want gasoline to have it.

There’s another benefit of high prices. They encourage greedy oil companies to pull oil out of the ground that isn’t worth pulling out of the ground when prices are low.

Getting oil out of the ground and into your car in the form of gasoline is an extremely expensive and unpredictable process.  ExxonMobil spent almost $15 billion last year on equipment to find new oil and make refineries more productive.

As consumers, we want oil companies to take risks and spend money searching for new supplies.  Profits are the reward for risk-taking and investment.  Take away profits when they’re high and oil companies will take fewer risks and invest less.  That means less energy in the future.

But isn’t the recent run up of prices just corporate greed run amok? I don’t know. At my local station, prices are down 85 cents per gallon from the peak of a few weeks ago. Did the owner just get nice overnight? Did he forget how to gouge? Did he figure he’d made plenty of money and it was time to give me a break? I actually think he’d still charge $3.50 a gallon if he could. But now that there’s more gasoline on the market, he can’t charge what he did before and still get my business. Too many competitors are charging less.

And next summer, if there’s no hurricane, what will happen if oil companies try and raise prices back to $3.50 per gallon? It won’t work. There’ll be too much gasoline to go around and prices will fall.

If the Senate does have hearings on oil industry profits, my fantasy is that an Exxon executive will have the courage to say:

“Yes, we made a lot of money last quarter. We earned it and we’d like to keep it.  And in those times when we make a lot less, or even lose money, we won’t expect to be bailed out.”

I doubt I’ll hear that.    But leaving profits alone and the incentives they provide, works better than having the government decide how much the oil industry deserves.

If you want to read more on how high prices encourage some to step aside and let others have the good, go here.

The biggest point I didn’t have a chance to make in 435 words is how much incentive is enough.  Surely, the oil industry critic would argue, there’s enough incentive for ExxonMobil when they make $6 billion in a quarter.  Do they really need to make $9.9 billion.  If I’d had room, I would have liked to have talked about the impact of adding political risk to investment decisions, an already risky and uncertain activity.  Then I’d have talked about the costs of having the level of profits be a political decision and how that affects the incentives of politicians to pander and businesses to spend resources and effort lobbying rather than looking for new oil.

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