Professor Paul Palley's
          Economics Seminars

Energy and especially oil prices are important variables to consider when evaluating both current and expected economic trends. Higher energy prices lead to higher costs for business and government operations, and higher costs associated with transportation, infrastructure development, and utilities. Virtually all economic activity is dependent on energy consumption to some degree. This means that evaluating trends and assessing energy price forecasts should be a critical part of decision-making. What the data shows is that during the period of 1986 to 2002 oil prices remained very low and in a narrow trading range except for a brief period in 1990 when oil price rose due to events around the Gulf War. Then during the period of 2003 to 2006 there was a period of steady increases in oil prices mostly due to global economic growth and economic development (especially in Asia). What occurred then in the 2007 to 2008 period was a sharp increase in oil prices. This spike in oil prices has increasingly been seen by analysts as a period of exceptionally strong speculative demand for oil rather than an increase supported by economic fundamentals. This indicates that speculation is an important factor in affecting oil prices as investors are free to choose from a range of investment opportunities including stocks, bonds, currencies, and commodities including oil. This spike in oil prices did not necessarily trigger the severe financial crisis and recession that started in December 2007, but it did not help either

 

There are many very good resources to go to follow trends, news, and issues related to energy. Among these include the Department of Energy, Energy Information Administration (EIA) which provides an excellent resource for those interested in energy related issues and topics, details about energy sources, state and U.S. historical data, and energy and oil prices data and forecasts. The link for this resource is: http://www.eia.doe.gov/. The current price of oil is approximately $75 per barrel. The Department of Energy, Energy Information Administration (EIA) projects steady increases in oil prices to sustained prices over $100 per barrel by the end of this decade (sustained is the key word here). This is logical as economic growth will increasing solidify the further we get from the recession of 2007-2009. The International Energy Agency (http://www.iea.org/) is also a very good resource for those interested in issues related to energy, and also related data and statistics as well as information related to energy technologies. In addition, the U.S. Bureau of Labor Statistics (http://stats.bls.gov/) is one of many valuable government resources. It can be an especially useful resource for both consumer and producer price indices, including those related to energy, infrastructure, and utility prices.

 

There are many other very good resources online that can be freely accessed for energy related news and information. The following is just a short list. The Wall Street Journal (http://online.wsj.com/home-page) is a good resource for daily business, world, and national news, including details about energy related topics and market data. Included in this coverage is news and reports focused on the commodities markets (http://online.wsj.com/public/page/news-oil-gold-commodities.html). There are Blogs that are also available to be read that periodically focus on energy related news and issues, topics, markets, and prices and are considered to be reliable resources for daily reading. Some of these include MarketBeat (http://blogs.wsj.com/marketbeat/), and Real Time Economics (http://blogs.wsj.com/economics/). The New York Times (http://www.nytimes.com/) is another good daily resource for business, national, and world news, including details related to energy related topics and market data. Separate science and technology sections are included in the online edition that periodically focus on energy related stories. The business section (http://www.nytimes.com/pages/business/index.html) includes a focuses on global markets, markets, and economy. The market related data and quotes include oil and other commodity prices. More specific to the topic is a separate section (http://www.nytimes.com/pages/business/energy-environment/index.html) whose focus is the energy and environment.

 

Daily details and news updates about energy, technology, and commodities and energy prices are available on other websites. These includes CNNMoney.com (http://money.cnn.com/), MarketWatch (http://www.marketwatch.com/), Yahoo!Finance (http://finance.yahoo.com/), and Bloomberg.com (http://www.bloomberg.com/?b=0&Intro=intro3) among others. The price quotes seen on these websites are the result of trading activity in the commodities markets. Information related to this is available through the CME Group (http://www.cmegroup.com/) which is a CME/Chicago Board of Trade/NYMEX Company.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Efforts to maximize profits over time focus on increasing revenues and reducing the cost of doing business. The ability of a firm to increase revenues will depend either on the ability of the firm to increase the demand for their product (outward shift of the demand curve), or to realize greater revenues due to a change in the price of the product (this depends on the price elasticity of demand). Invariably, the market structure within which the firm competes will also greatly impact the ability of a firm to enhance its profits. On the other hand, efforts to reduce the average costs associated with producing a product depends on the ability of a firm to more effectively utilize its resources or to employ new technology to increase productivity.

All firms maximize their profits when they produce a level of output where the marginal revenue equals the marginal cost. The logic is as follows; as long as the marginal revenue exceeds the marginal cost then the additional revenue that results from producing the next unit of output will exceed the cost associated with producing the next unit of output. As a result, the firm will see its profits increase and it should produce more. It will then produce more, and continue to do so until the marginal revenue equals the marginal cost because every unit of output produced up to this point will lead to greater profits. With this definition established, the next step is to focus on each market structure.

In the case of firms that compete in the pure or perfect competition market structure, the problem of profit maximization is a very difficult one to solve. They are contrained to charging the market price and they participate in a market structure where firms are free to enter at will. Any profits lead to new entants and those profits will then disappear. As a result, these firms will focus primarily on cost control. They look to become more productive as a way to lower their average and marginal costs. The classic example of these firms would be that of farmers. Farmers are largely tied to market prices as they are determined in the commodity markets. You will therefore see them focus on cost management.

Monopolists face the market demand curve because they are the only firm providing the good or service in that market. As a result, on the revenue side of the equation they can focus on the price they charge and also seek to increase demand for their product (outward shift of the demand curve). Adjusting the price they charge will either lead to an increase or decrease in revenues depending on the price elasticity of demand. If demand is price elastic then higher prices will lead to lower revenues but lower prices will lead to an increase in revenues. If demand is price inelastic then higher prices will lead to higher revenues but lower prices will lead to an a reduction in revenues. Many monopolists face a demand curve that is price inelastic (local utilities are a classic example). The other opportunity to increase revenues will be through marketing efforts, the introduction of new products, or by exploiting changes in economic conditions, to enjoy an increase in demand. Then at any given price people will want to buy more of thei firm’s products. Remember also that any change in output will lead to a change in the cost of production. The firm must keep this in mind. If the firm is operating at a point of diminishing returns then the firm’s marginal and average costs will increase as ouput increases. The firm will seek to mitigate this by working to employ new technologies or other means to increase productivity and lower the firm’s marginal and average costs.

Firms who compete in the monopolistic competition market structure face the same opportunities that monopolists do in that they can attack both the revenue and cost sides of the profit equation, but with a very important difference. They have to contend with many more competitors producing similar substitutes leading to a demand curve that is far more price elastic. As a result, higher prices will lead to lower revenues but lower prices will lead to an increase in revenues. The problem with lowering their prices is that competitors can follow suit leading to price wars. The lower prices may also hurt their image in the marketplace. Instead, monoplistic competitors will seek to differentiate themselves from their competitors in order to retain control over the price they charge (restaurants are good examples of this). The cost side is also important because they do face a significant amount of competition and as a result they face a lot of price pressures. They will therefore work to increase productivity to manage their costs. The oligopolist faces the same issues monopolistic competitors face, but the number of competitors is greatly reduced. As a result demand tends to be more price inelastic. The competition among a small group of strong competitors can be very fierce making product differentiation very important.

Think about the firm you work for. How do they maximize profits and what competitive conditions do they face that affect their profit outcomes?

Here are two links that argue that marginally higher inflation rates would be beneficial in two ways. The first is that it would justify higher wages, and second that because it would result in higher nominal interest rates. These higher nominal interest rates would allow for more flexibility by the Federal Reserve and other central banks to lower interest rates when necessary to fight recessions. This is a controversial proposal because over the course of the last three decades low inflation targets have been set by central banks, emphasizing the importance of low rates of inflation. As a result a change in policy would be required. Then again, very low inflation and interest rates are identified as factors contributing to the financial crisis that deepened dramatically in 2008. At the same time policy makers would need to make sure that inflation does not get to be too high due to the change in policy. Here are the links to the first article (http://www.imf.org/external/pubs/ft/survey/so/2010/INT021210A.htm) and the second article (http://elsa.berkeley.edu/~akerlof/docs/inflatn-employm.pdf).

 

What do you think?