Why Harvard Law School Should Teach Its Lawyers Economics

Last week, President Obama called for the repeal of a $4 billion tax incentive for domestic oil and gas production. His argument is that the oil and gas industry is doing quite well and does not need any help from the government.

In the long-term, the President is right. Oil and gas companies do not need these incentives in perpetuity.

That said, the President could not have chosen a worse time to repeal these incentives. In the short-term, repealing this tax incentive now, when gasoline prices are high, will only push gas prices even higher.

In essence, this action will exacerbate the very problem that the President appears to be using as a wedge issue for his reelection campaign.

Why?

Basic economics.

Not only will gas prices rise, but they will disproportionately impact consumers.

In the short-term, gasoline has a low price elasticity of demand. This economic term is just a fancy way of say that people are insensitive to large changes in the price of gasoline. They are insensitive because they still need gasoline to get to work and take their children to school. They will reduce their travel at the margin, but the market price needs to rise to even higher levels before they do so.

Basic economics dictates that when a tax is levied on a good with a low price elasticity of demand, those demanding that good will bear more of the price impact than those who supply it.

This happens because adding a tax requires an oil firm to charge more money for each gallon of gasoline to offset most of the tax. Because consumers need to buy the gasoline, the company passes the majority of the tax onto the consumer through price increases.

Below is a graphic illustration of how this logic plays out both before and after the tax.

Source: Economics by John B. Taylor

Either Obama does not understand basic economics or he does, but is conveniently ignoring it for political gain. 

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About Sean Patrick Hazlett

Conservative clean energy crusader, national security hawk, financial analyst, engineer, and former military officer.
This entry was posted in Business, Energy Security, Finance and Economics, International Security, Media, Policy, Politics, Taxes and tagged , , , , , , . Bookmark the permalink.

8 Responses to Why Harvard Law School Should Teach Its Lawyers Economics

  1. pino says:

    Either Obama does not understand basic economics or he does, but is conveniently ignoring it for political gain.

    I suspect its both; he DOESN’T understand economics AND hes doing it for political gain.

    I’m all for lower taxes but I’m also all for the government not picking winners and losers in the energy “evolution”. If we tax, or not tax, oil companies, we should tax, or not tax, in the very same manner – solar companies, wind companies, gerbils chasing Budweiser companies or ethanol companies. Let the best man, gerbil, win!

  2. Scott Erb says:

    Not sure I agree. I took a course in “The Economics of Non-Renewable Resources” back in grad school, and a lot of the rules change when you deal with a resource where the cost of production is constant, and often only somewhat related to the price. In this case oil production will not dramatically increase or decrease regardless of what the price does, at least in the short term. That means that increased prices means clear increases in profit, since they do not generate the increased supply that usually comes when prices go up. (Usually if profits and prices increase, producers come into the market wanting a piece of the action, which increases competition and brings profits down). So in this case, higher taxes might not be passed on, since price is a function of supply and demand, and taxes do not affect (or minimally affect) this. I’ll think about this more, but my initial reaction is that the nature of the oil industry alters the traditional economic read.

    A stronger argument would be that the oil companies need this increased profit to invest in finding new oil sources or developing alternatives. One reason I don’t get too upset about high oil company profits is because I figure this also means a lot more investment into energy supply.

    • “I took a course in “The Economics of Non-Renewable Resources” back in grad school, and a lot of the rules change when you deal with a resource where the cost of production is constant, and often only somewhat related to the price. In this case oil production will not dramatically increase or decrease regardless of what the price does, at least in the short term.”

      Scott, the cost of oil production is anything but constant. As firms move from secondary recovery methods to tertiary recovery methods and drill deeper and deeper off the Continental Shelf, the price of production continues to rise.

      “In this case oil production will not dramatically increase or decrease regardless of what the price does, at least in the short term.”

      Your point here is spot on and makes the point that oil has a low price elasticity of demand. Because expanding oil production capacity takes years, oil firms can not rapidly respond to a surge in demand, therefore, when prices go up (even because of a tax), there production only declines slightly, yet consumers still demand a similar quantity of oil, despite these price increases.

      “Usually if profits and prices increase, producers come into the market wanting a piece of the action, which increases competition and brings profits down”

      Again, you are spot on here. However, this does not happen in the short-term (because new producers must discover more oil and install rigs to extract it). It happens in the long-run. Therefore, any tax increase will be borne disproportionately by those demanding the product in the short-term.

      “A stronger argument would be that the oil companies need this increased profit to invest in finding new oil sources or developing alternatives. One reason I don’t get too upset about high oil company profits is because I figure this also means a lot more investment into energy supply.”

      I think this is true if you are an oil company trying to justify why you receive a tax credit. What I am upset about is that the President is advocating a policy that will raise prices on consumers in response to their complaints about price. It simply does not make economic sense to me. It does, however, make some political sense.

      • Scott Erb says:

        But will they raise prices, or just reduce profits? I think the price at the pump is determined by the oil market, with taxes relatively inconsequential (excluding, of course, the tax paid at the pump). My reasoning is that if production costs do not matter in terms of price increases, neither will additional taxes.

        You pass on a tax increase to consumers because it directly impacts the market. It costs more to produce and in a normal market the difference between the cost of production (including all that goes into getting it to market) and the price of the product tend to get close to equal. A higher tax pushes the cost of production higher forcing a price increase in order to maintain profitability. But oil is reaping huge profits so there is arguably little impact on the market by having them pay more taxes.

        IOW, it’s this sentence in your post I’m having doubts about: “This happens because adding a tax requires an oil firm to charge more money for each gallon of gasoline to offset most of the tax.”

        I don’t think the cost of producing oil is what determines the price since demand is such that people will produce as much as they can. (Though I agree that in the long term it makes a big difference — that’s why it seems to me that in the short term it may not affect price, but might make it more expensive to expand supply in the long term).

        • “But will they raise prices, or just reduce profits”

          There is no question that they will raise prices. If their margins decline, the stock market will hammer them.

          “I don’t think the cost of producing oil is what determines the price since demand is such that people will produce as much as they can.”

          Sure it does as do capacity constraints. That’s what’s driving the huge tar sands boom in Alberta right now and the development of offshore drilling techniques. In the past, these activities were cost prohibitive (i.e., their cost of production). So long as oil prices are high, companies can make a profit here. But the cost of production for one driller is not the same for another.

          Anyhow, the short-term impact of a tax increase will lead to higher prices as surely as gravity.

  3. Scott Erb says:

    OK, I explained my thinking to an economist here. She understood my argument, but said she also thought they would get away with passing taxes on to consumers, soI was wrong to doubt you. She did argue that low prices is not something we want, since we need to conserve and be pushed to alternatives. What we want are stable prices — but to use a tax to achieve that it would have to be variable and tax greater when the prices are lower. Politically, of course, that’s a non-starter.

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