Understanding markets — A primer for Senators from Illinois
Senator Obama's proposal to tax oil companies to give Americans a refund is a bad plan for many reasons. But perhaps the biggest reason is that it will result in higher gas prices. Don't believe me? Let's review some basic economics.
The law of demand essentially states that, all other things being equal, the amount demanded of a good will decrease as price increases. For example, consider the example below:
| Price | Quantity Demanded |
| $1 | 50,000 |
| $2 | 40,000 |
| $3 | 30,000 |
| $4 | 20,000 |
| $5 | 10,000 |
The law of supply essentially states that, all other things being equal, the amount supplied of a good will increase as price increases. For example, consider the example below:
| Price | Quantity Supplied |
| $1 | 10,000 |
| $2 | 20,000 |
| $3 | 30,000 |
| $4 | 40,000 |
| $5 | 50,000 |
When we consider the two curves together, we see that the market reaches equilibrium at 30,000 units, and a price of $3.00. At $3.00, the quantity supplied is exactly equal to the quantity demanded. Everyone is satisfied.
| Price | Quantity Demanded | Quantity Supplied |
| $1 | 50,000 | 10,000 |
| $2 | 40,000 | 20,000 |
| $3 | 30,000 | 30,000 |
| $4 | 20,000 | 40,000 |
| $5 | 10,000 | 50,000 |
What happens if sellers decided to raise the price that they charging to $4.00? At $4.00, the quantity demanded is only 20,000. However, the quantity supplied is 40,000. The market will sell the 20,000 units demanded, but there will be 20,000 surplus units on the market that will not be sold. The people selling those units will have to drop the price back to $3.00 to sell them. Let's consider this in the context of a simple example. Suppose that each unit costs me $0.50 to make. At $3.00 per unit, the market for my product is 30,000 units, and I will make $2.50 per unit. Total profit is $75,000. At $4.00, my margin is higher, $3.50. But I can only sell 20,000 units. My total profit will be $70,000. There is also an additional problem. Because the "real" price is $3.00, my competitors will enter the market at that price. I will soon be priced out of the market.
What happens if we mandate a lower price than the one the market will bear? This is referred to a price ceiling…and it results in an inefficacy in the market. For example, suppose the government passes a law that says that I can only sell my units for $2.00 or less.
In this case, the market will demand 40,000 units…but the market is only willing to supply 20,000 units. This will result in shortages. Not everyone who wants a unit can get one. The only way to alleviate this condition is to reduce demand in some way, increase supply, or to remove the price ceiling.
What about a price floor…a law that mandates a minimum price for something? For example, a law that says I can only sell my units for $4.00 or more?
This results in the same situation as discussed earlier. The market will demand 20,000 units, but supply 40,000 units. There will be 20,000 units on the market that no one wants. They will have to be bought by the government, or scrapped. (In fact, this is exactly what happens with agricultural products. Where do you think government cheese comes from?)
You will note that I said earlier "all other things being equal" and used the term "quantity demanded." In the example above, where we changed price, neither demand nor supply changed. The quantities demanded and supplied changed. It is also possible to shift the supply and demand curves to the right or left. For example, adding a tax to something increases it's real cost. This will tend to shift the demand curve left, as consumers demand less of a good. Taxes on suppliers will shift the supply curve to the left. Subsidies tend to shift the supply curve right, as suppliers can have the same profit at a lower price. Improving economic conditions will shift the demand curve right, since consumers will have more money to spend on a good.
With this background in mind, let us review Senator Obama's plan for change. He plans to increase taxes on oil company profits in order to fund a $1000 tax rebate for consumers. Increasing taxation on oil companies will shift the supply curve left. Oil companies will supply less, and divert their efforts into non-taxed businesses. The $1,000 check will shift the demand curve to the right, as consumers will have $1,000 more to spend on gas. Lets look at this effect in our hypothetical units:
| Price | Old Quantity Supplied | Old Quantity Demanded | New Quantity Supplied | New Quantity Demanded |
| $1 | 10,000 | 50,000 | 0 | 60,000 |
| $2 | 20,000 | 40,000 | 10,000 | 50,000 |
| $3 | 30,000 | 30,000 | 20,000 | 20,000 |
| $4 | 40,000 | 20,000 | 30,000 | 30,000 |
| $5 | 50,000 | 10,000 | 40,000 | 20,000 |
| $6 | 50,000 | 10,000 |
The market reaches a new equilibrium point, this time at $4.00, in our example.
That's right….the plan will result in higher gas prices. Well done, Senator.
(Hat tip to Bitter)