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Brooks Wilson's Economics Blog: Oil and Two of Mankiw’s Ten Principles of Economics

Friday, January 14, 2011

Oil and Two of Mankiw’s Ten Principles of Economics

Greg Mankiw’s seventh principle of economics is that “governments can sometimes improve market outcomes.”  Modifying “can” with “sometimes” is common economic analysis built on tons of experience.  The production and consumption of oil exemplifies the problems that even government with the best of intentions faces.  We often associate oil production and consumption with two market failures: market power and negative externalities (pollution), and they are partially offsetting.  A government response to market power is to create more competition which would increase output, decrease price, and increase the negative externalities.  A government response to negative externalities is to impose a tax that would decrease production and consumption and drive up prices.  

The issue of oil production and consumption is more complex still.  Oil, and the products derived from it, add greatly to our national wealth.  At present, it does not have good substitutes.  In addition to directly creating wealth, it also creates positive externalities as do all market based transactions.  Because it is the cheapest form of energy for many uses, someone else’s use of oil benefits me because its consumptions leaves them wealthier and more able to buy the goods and services that I produce.  We know that steeply rising oil prices can act stop economic growth or even throw it into reverse.  (HT Drudge Report) That is why our eyes are on OPEC as the price per barrel of crude oil approaches $100 (Gene Ramos, “Oil off on U.S. data but OPEC eyed as $100 in sight”). 

Mankiw’s sixth principle is that “markets are usually a good way to organize economic activity.”  How do markets help?  In response to higher prices, consumers will shift consumption to energy efficient products.  Companies that make products that are not energy efficient will lose business unless they can modify their products to use less energy.  Markets even help solve market failures.  Pollution is often a sign of inefficient production.  Learning from BP’s example, oil companies will be more careful when drilling, not just to avoid cleanup costs, but to not waste a valuable resource.  The internal combustion engine has grown more efficient in part by polluting less.  A fuel efficient car in 1972 got about 25 miles per gallon on the highway, less than most modern minivans.  Firms exercising market power by withholding product to raise prices will face new competition from firms that want to grab part of the high profit market power creates.  Schumpeter referred to innovation threatening existing producers as the “winds of creative destructions.”  Are these winds sufficient to blow away oil’s twin market failures of market power and negative externalities?


  1. Lori Hodges14/1/11 9:18 PM

    I like Joseph Schumpeter's paradoxical term "creative destruction", the free market messy whay of delivering progress. The oil prices have been raised to the point that I feel gouged and tired of the inconsistency of gas prices. Which leads me to the thought of Principle 7 "Where is the government on improving the market outcome. Our first goal should be efficiency. Will a foreign country take the lead on an electric car?

  2. Brandon Guthrie20/1/11 12:00 AM

    I believe another one of the ten economic principles that affects most markets but especially the oil market is that of facing trade-offs. One of the trade-offs that our government must face is how many laws to enact that governs oil production to lower pollution. If they enact very strict rules this would defiantly raise the cost to produce oil, which would in turn greatly increase the price that we all have to pay to get this very scarce resource. This option might lead to pollution being limited to a much smaller amount to keep our world safer. On the other hand, the government could choose to let the oil industry produce their oil in the easiest and cheapest way possible which would give us, the consumer, the cheapest price possible. Unfortunately, as with any trade-off, this would possibly leave us with staggering pollution rates. As you can see even the government faces major trade-offs in the oil field, and their choice directly effects the oil market, its future, and most directly to us, our wallets.

  3. Barbara Garcia20/1/11 9:26 PM

    Okay, giving this a try..

    The first principle of economics, being trade-offs, is applicable to the oil market.. but is it possible that the second, being decision making, is also true of this?
    You're buying a car; new or used? American made or foreign? and what about the cost to insure it?
    The car industry is evolving, but so is the price to maintain your lovely new ride. I believe consumers are being making more conscious decisions about their wagon of choice. Tires, brake pads, and other services are costly.. but, they remain at a constant price. Oil production has been fluctuating for the entirety of the recession, and now we consider not only the cost of the car, but the cost to maintain more than ever before. Follow me so far? So, as a car buyer, your dream of the two-door coupe might have to wait for later.. suddenly, the used '03 GMC looks much better. Your brand new Coupe can't run on the standard quart of oil. Can you say synthetic? The GMC looks much more affordable to you. This is when we see an opportunity cost; predicting the cost of oil for this new ride is unnerving. Instead, you drive away in the GMC, because the stability of knowing you can afford it, even in the economic condition we face, beats the possibility of repo.

  4. Mankiw's first principal of people facing trade-offs is especially true in modern over oil. Over the next 25 years as poor nations begin to catch up with traditionally industrialized countries we will begin to see a shift in natural resource consumption. Rich nations produce little and consume the goods and services of poorer nations flooding them with capitol and jobs.

    Gone will be the days of a small minority of rich countries consuming the large percentage of available resources. With a growing demand from countries like China and India competing with western powers it seems that hording or hiding stock piles to artificially raise prices will be in practical or unnecessary for the long-ter.

    For the short-term the practice of concealing oil to drive up pries would be marginal at best because of the competition as well as a fragile and weak global economy overly dependent.

  5. The sixth priciple of economics which is markets are usually the best way to organize economic activity. This principle is the one I agree with the most. I believe the market driven society is the best one for all of society. Companies such as BP are about making profits for themselves and their shareholders. It is to their benefit to be as efficent and productive as they possible can.If consumers demand a cleaner less polluting source of energy and there is a profit to be made someone will find it and get it to market, again to make the profit that is avaliable.

    I also believe that corporations want what is best for the country and its consumers.I dont think any major oil company wants its name being connected with major, unchecked pollution. This can create a conumer backlash for their products and less profits.

    Oil production and consumption is a very complicated issue. I have read conflicting reports on how scarce a resource oil is. Some reports say we have enough oil for a very long time some reports say otherwise. If the government taxes oil to create less demand for the product it will make other sources of energy apppealing such as wind. The government did this with cigarettes.They raised the taxes on tobacco to reduce the negative externalities of tobacco use on our health as a nation.

    Elizabeth Rainwater