[murphy560]

Professor Herbener, all I hear about these days is how the price of oil has dropped directly leading to a drop in gasoline prices. In my studies of Austrian economics I’ve learned that the causal link is reversed and that the prices of consumers goods determine the prices of producers goods but it’s difficult to trace out the cause and effect in some real world situations. Can you discuss the causal connection between prices of consumer/producer goods in the context of the present dramatic drop in gas/oil prices?

[jmherbener]

What needs to be kept in mind in tracing cause and effects throughout the economy is that the economy is a single system of production under the division of labor integrated by the structure of prices. The goal of the system of production is to economize the use of people’s resources in the satisfaction of their consumptive ends. When people’s consumptive demands change it sets in motion a reconfiguration of the entire structure of prices and production throughout the economy. Without government intervention, the process of the market generates the most efficient use of resources and build up of capital capacity possible.

Two factors have been at work in fuels.

First, the natural process of economic development has been at work. Worldwide consumer demand for gasoline has been increasing driving up gas prices. This cause alone would increases the profitability of gasoline production leading entrepreneurs to increase their demands for oil and other inputs which, in turn, would drive up oil prices and the prices of other inputs, which in turn would increase the profitability of producing more oil. If profitable enough, other entrepreneurs would invest in technological innovation to increase oil production and use of the new technologies would increase production and the greater supply of oil lowers its price which moderates the rise in price of gasoline, given the initial rise in demand for gasoline.

Second, government intervention has been at work. Governments have increased taxes on gasoline depriving entrepreneurs of the funds to expand production. They have also erected legal restrictions of further conventional oil production. Governments have also destroyed the capacity for conventional oil production in their wars over the last twenty years. The resulting artificially high price of oil has made investment in alternative technologies to circumvent convention production even more profitable. Entrepreneurs have responded with the fracking boom, vastly increasing oil production and lowering its price.

The reason gasoline prices have fallen is not because they are determined by oil prices, but because speculators anticipate profit from moving gasoline supplies from the future to the present in the wake of the greater future production of gasoline they anticipate. The increase supply moves along a given demand curve to clear the market at a lower price for gasoline. The (now lower) price of oil and other (now lower) input prices are still determined by that (now lower) price of gasoline.

[murphy560]

What about the following scenario: Technological innovation (i.e. fracking) causes expansion of production in a factor market. The resulting drop in price of the producers’ good (i.e. oil) causes a.) current gasoline producers to lower their selling price/increase production due to changing cost structure in order to maximize profits under the new market, or, b.) new gasoline producers enter the market due to increased profit expectations and the resulting increase in gasoline production leads to lower prices? Wouldn’t both of these scenarios be plausible and wouldn’t they both be examples of lower factor prices causally leading to lower consumer good prices? Thanks as always for your time.

[jmherbener]

Technological innovation requires capital investment which entrepreneurs determine by economic calculation. Entrepreneurs consider all the different lines of investment in all the stages of production and invest in that set of lines which they anticipate will prove to be the most profitable. But the profitability of each line of investment can be traced to its contribution to satisfying consumer demands.

So, the scenario would be: (1) Because of rising consumer demand for gasoline (and government restrictions on production and supply) the price of gasoline rises. The high price of gasoline makes investment in new technologies for producing oil more profitable. Entrepreneurs investing in fracking technology and then the drilling equipment and land rights, etc. They expand oil production capacity to the point at which they anticipate that the lower than otherwise price of oil and the higher than otherwise prices of drilling equipment and land rights, etc. will make further investment in oil production capacity unprofitable. The reason oil prices fall with increased supply is that entrepreneurs know that gasoline prices will fall with increased production and supply of gasoline from the increase production and supply of oil.

The costs of oil production by fracking are higher not lower than with other methods already in use.

http://www.businessinsider.com/saudi-arabia-can-hold-out-2015-1

What justifies investment in higher cost techniques of oil production is the higher price of gasoline. The innovations in fracking techniques made extraction of shale oil cheaper than with the techniques previously used, but even with the new techniques fracking costs are higher than methods already in use. That’s why they haven’t been adopted until now when the higher price of oil justifies their use.

http://www.marketplace.org/topics/sustainability/oil-man-who-figured-out-fracking

Even if for some reason the price of an input fell in the market, lowering costs of production of output, the new, lower price of the input depends on entrepreneurial demand which depends, in turn, on consumer demand for the output. For example, let’s say that demand for cigars vanishes causing tobacco prices to fall. The new, lower price of tobacco is still determined by entrepreneurial demand for tobacco, which is determined by, the now lower, consumer demand for cigars, cigarettes, and other consumer goods using tobacco as an input.

[murphy560]

That makes perfect sense…you’re brilliant. Thank you again.

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