Bastiat’s Bastions

This last week and this weekend I wrote a paper with Gary Pecquet of Central Michigan University on ANWR oil. Chad Turner gave me some help, so any errors are his fault—just kidding, they are Dr. Pecquet’s fault. Some of my students may recognize the idea, as I used it on a recent exam. Here is the gist of the paper taken from the introduction.
Everyone knows that oil discovered today, say at the Alaskan National Wildlife Refuge (ANWR) will not have any effect on prices until that oil hits the market. For instance, on its website, the Democratic Policy Committee (2006), (http://democrats.senate.gov/~dpc/pubs/107-1-72.html) states that “it will require seven to twelve years from approval before there is any oil production from the ANWR area. Therefore, production in ANWR will have no impact on current or short-term gasoline and oil supplies and prices.” While this is something that “everyone” knows, it is another example that the theory held by “everyone” happens to be wrong.

Using oil now reduces the amount of oil that will be available for the future, and so, the higher the price, and the higher is profitability of oil in the future. The more profitable it is to produce and sell oil in the future, the greater will be the opportunity cost of selling oil now instead of waiting to sell it in the future. This opportunity cost of selling now instead of waiting to sell it sometime in the future is called the marginal user cost or the scarcity rent of the resource. This is a cost of producing the oil just like the cost of pumping the oil, sometimes referred to as the marginal extraction costs.

If oil in ANWR is approved for production and that oil will reach the market in 10 years, it will surely reduce oil prices in 10 years, reducing future prices to something less than they would have been if the oil were not being produced. Since future prices are expected to be lower, future profits are also lower, so the value of oil not produced now, but held for future sales, is lower, making it more profitable to go ahead and produce and sell the oil now instead of waiting for future profits, as the opportunity costs will be lower. Oil from wells that are already producing can produce more now or can be slowed to produce more of its oil at some future date.

We use a simple two-period model (now and the future) to show that if an amount of oil that is discovered is significant enough to reduce prices in the future, that drop in future prices reduces the future profitability of oil, reducing the marginal user costs or the scarcity rents of oil now. That reduction in the marginal user costs reduces the current price of oil just as if there were instead a reduction in the marginal costs of extracting oil now. We explore the effects of the reduction in marginal user costs in a monopoly scenario, in a competitive scenario and one where a monopolist or dominant supplier responds to a substantial discovery by another seller, but where the discovery will not contribute to production for some years to come. We find that in all of our cases the discovery of oil that is expected not to reach the market until some years hence still has an immediate impact on oil prices.

Morris Coats

This entry was posted on Friday, November 3rd, 2006 at 10:26 pm and is filed under General, Political Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.