The Answer Is In the Margin

by Don Boudreaux on May 27, 2007

in Energy, Myths and Fallacies, Prices

Muirgeo asks, in response to this post on Congress’s latest effort to keep the price of gasoline below its market-clearing level:

Can anyone tell me why the oil companies would want to build a refinery when profits are so high just the way they are?

Also in the Comments section, The Albatros and Methinks offered very nice answers.  I offer here my own response — or, actually, a response to a Washington, DC, radio news anchor who asked on air the very same question that Muirgeo poses:

News Editor, WTOP Radio
Washington, DC

Dear Editor:

Morning anchor Mike Moss proposes that the U.S. government enter the business of gasoline refining.  He argues that the private sector has no incentive to build more refining capacity as long as oil-company profits are high.

Moss’s economics is backwards.  It implies that private firms would consistently refuse to expand outputs of MP3 players, gourmet coffee, cell phones, and other high-demand products.  Firms instead would invest only where profits are low or negative – treating consumers to endless supplies of the likes of chocolate-coated olives and cardboard condoms.

In fact, of course, the profit motive drives firms to invest precisely where returns are highest — assuming that they’re not thwarted by government regulations.

Letters to the editor must be short, inevitably resulting in some simplification.  If the oil-refining industry were monopolized or if its firms could effectively cartelize, then any high profits currently earned would be less likely to spawn new investment in refining capacity.  I have no sense that the oil-refining industry enjoys monopoly power (except, perhaps, insofar as government regulations that artificially raise the costs of building new refining capacity do help to shield existing firms from the full force of market competition).

More directly, although I can’t read minds, the impression I got from listening to the radio announcer, and from reading Muirgeo’s comment, is that these persons commit the same fundamental economic mistake that many freshman students commit: the failure to think at the margin.

Thinking ‘at the margin’ reveals that, yes indeed, if profits are higher for sellers of product A than for sellers of product B, devoting resources to the production and sale of more units of product A will yield higher returns on those resources than would be yielded on those same resources were they instead used to produce and sell more units of product B.

In this way, high profits direct resources owners to use their resources where the return available on those resources is highest — which is generally also where those resources most ably satisfy consumer desires.


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