Economists Do It With Models

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Dear BP: I Would Like My 75 Cents A Pound Back Please…

May 28th, 2010 · 7 Comments
Econ 101 · Environmental Econ

Let me get the typical reactions to the BP mess out of the way first: RAWR! Oil everywhere! RAWR! Pelicans! RAWR! Should have been more careful! RAWR! Who would have thought that giant oil funnels were not a good idea? RAWR! Maybe Kevin Costner can save us! (Not even kidding.)

Now that we’re all caught up…I know people are upset about what is going on in the Gulf of Mexico, but it’s important to remember that in a brilliant (read, desperate) PR move, BP made it clear that it is going to pay all of the costs of oil spill cleanup. (Yes yes, I know we are going to have to wait and see whether that actually happens.) This seems fair, to a degree, but it’s certainly worth noting that simply paying to clean up the mess isn’t going to compensate everyone for their losses. BP seems to understand this, so it has clarified what is covered under the heading of “cleanup costs”:

In a fact sheet posted to the company’s website Monday, the British-based BP also said it will pay compensation for “legitimate and objectively verifiable” property damage, personal injury and commercial losses.

Okay, so BP does seem to realize the strain that it is putting on people in the fishing industry, for example, and it’s vowing to compensate the fishermen for the fact that it’s kind of hard to sell fish that has been pulled out of an oil slick. (I’ve heard of oily fish before, but this is ridiculous.) What BP doesn’t seem to understand is the way that the forces of supply and demand work. Consider the following, via Environmental Economics:

The supply of Gulf Coast food — and the cost of it — fluctuates on a daily basis, with the NOAA Fisheries Services map of safe and affected fishing waters constantly being redrawn. ABC reports that in light of the reduced amount of seafood on the market, “Fish that normally sold for $2.50 a pound were going for $3.25.”

Well duh. The oil spill has made it more difficult for fishermen to find and catch untainted fish, so they are now bringing in less fish than they were before, even though they are putting in the same level of resources as before. Economists categorize this as a form of reduction in technology, and a reduction in technology results in a reduction in supply, mainly because the decreased technology makes the fish more expensive and thus less attractive to produce. (See here for a video refresher.) This reduction in supply leads to a higher market price for fish and a lower quantity of fish sold. (Again, see here for a little video on the topic.)

The point that often gets lost is that both consumers and producers of fish lose out when the fish becomes more expensive to produce. Fishermen can’t push all of their cost increases onto consumers, and consumers can’t make the fishermen eat the entire amount of the cost increase. We can quantify (or at least graph) the change in value for both consumers and producers in the market for fish:

The solid lines are the original supply and demand for fish, and their intersection corresponds to the price of $2.50 and whatever quantity of fish was originally sold. The dotted supply line represents what happened to the supply of fish as a result of the oil spill (note that this is a shift of supply to the left, which represents a decrease), and where this line meets the demand curve shows the increased price of $3.25 and the new quantity of fish sold. As I said above, the reduction in the supply of fish leads to an increase in price and a decrease in the quantity sold of fish.

It’s not surprising the consumers lose out in this deal, since they get less fish and they pay a higher price for it. The solid blue triangle on the graph is how much value the fish market provides to consumers after the supply decrease, and the hatched area is the amount of value lost by consumers because of the supply decrease. (The value before the supply decrease is the solid and hatched areas put together.) Some consumers lose out because they are still buying fish but paying a higher price for it, and other consumers lose out because they used to benefit from buying fish but the higher price has pushed them out of the market entirely.

How does the value to producers change as a result of the supply decrease? This change is less intuitively obvious, since producers sell less (fewer? I apparently can’t decide whether fish are countable.) fish but they get a higher price for the fish that they do sell. I said before, however, that the fishermen can’t pass along all of the cost increase to their customers, and that means that their margins are going to go down because of the supply decrease. In this way, the fishermen are indeed also losing out, since they are getting lower margins on fewer fish:

In this case, the solid triangle is the value to producers after the supply decrease, and the hatched triangle is the value to producers before the supply decrease. (Note that the areas overlap a little- it was hard to clearly indicate that with a Sharpie.) It’s harder to see, but it is indeed the case that the new triangle is smaller than the old one.

Who loses out more- producers or consumers? It’s actually not clear, since it depends on the relative elasticities (read, price-sensitivities, or see here for a video) of supply and demand. If consumers are insensitive to price, for example, producers will be able to push most of the cost increase onto them and not have to suffer much in terms of a reduction in quantity sold. Therefore, if consumers are less price-sensitive than producers, they will lose out more from the oil spill, and vice versa.

I bring this up because none of BP’s PR grandstanding addresses the cost to the consumers of the goods that are affected by oil being all over the place, but it’s a cost that is very much present and relevant. Granted, it’s a harder cost to reimburse, since the buyers are more spread out than the sellers, and it’s not really obvious how to find those people who stopped buying fish altogether because of the price increase. Economically speaking, if BP reimbursed the fishermen in real time for their cost increases rather than just for their lost profits, the market should be able to adjust to distribute that reimbursement properly, but that doesn’t address how to retroactively compensate for the damage that has been done. Therefore, I am hereby requesting that BP reimburse me 75 cents a pound for all of the fish I have bought in the last 40 or so days. I’ll even be nice and let the accrued interest on that amount slide.

Sincerely,
econgirl

Tags: Econ 101 · Environmental Econ

7 responses so far ↓

  • 1 John F. Opie // May 28, 2010 at 2:16 pm

    Hi –

    You’re absolutely right: will BP reimburse consumers for higher prices?

    In a word: no.

    On the other hand, if they were to do so, did you save the receipts for all that fish (in general, since the price increases affect all fish prices) you bought in the last 40 days?

    If not, then the quantifiable risk for BP just dropped significantly (assuming, of course, that you are a typical fish consumer). If you did, well, that’s an interesting side to your personality… 🙂

    Further, let’s leave the fish out of it: will BP also compensate us for the increased price of oil due to the fact that they’re pumping it into the ocean rather than into our fuel tanks?

    BP can’t afford to pay for those damages and remain a viable oil exploration and exploitation company, unless the penalties are capped. If the penalty cap is too low, then they just write a check, shrug their shoulders and walk away, leaving the government (aka taxpayers) to pony up for the difference. Ratchet that cap up far enough and the US government owns BP because BP will have to dedicate future oil revenues for the next 20 years to resolving the problem, and all other companies will leave the deep-sea exploration business, except, of course, the state-owned companies like those of Brazil and elsewhere, who will simply ignore this.

    And let’s not even get into what fair compensation might be for ruined vacations because the beaches were covered with tar babies. Here we can be certain that the vast majority of claim payments will be consumed by those ugly, bottom-dwelling, cold-blooded creatures known as class action lawyers…who oddly enough generally give money to the Democrats…

    Hence President Obama may be hurt right now from the political fallout of his relative inaction, but will perhaps gain because the tort lawyers will be rolling in dough as they pick the carcass of BP and will support his re-election…

    Cynical? Me? Nawwww.

  • 2 Scott Ritchie // May 29, 2010 at 4:43 am

    Relatedly, I’ve noticed that if I’m unhappy with a fish purchase the store gets even more unhappy when I return it.

  • 3 Jonathan // May 29, 2010 at 2:23 pm

    “other consumers lose out because they used to benefit from buying fish but the higher price has pushed them out of the market entirely.” True but their losses are only about half the losses of those who continue to consume, since they have the money for other alternatives. Between those just indifferent between fish and tofu and those for whom the 75th cent per pound caused them to switch, the average loss is about 37.5 cents perpund of fish formerly consumed.

  • 4 jody // May 30, 2010 at 12:38 pm

    Someone should combine the teaching of current events and economics because, no matter what happens, “there’s a graph for that!”

  • 5 Joshua // May 31, 2010 at 5:29 pm

    EDIWM, good post! I’ll add that this little gem, ““legitimate and objectively verifiable” “, will most likely mean, “verified by a judge and upheld by an appellate court.” I don’t know that for a fact, but…

  • 6 Charles Dolci // May 31, 2010 at 9:02 pm

    Something seems to be missing from these calculations. We are discussing increases in the price of fish for consumers and loss of revenues for fisherman. It all seems to ignore a few facts – that is, we live in a REAL world, with REAL people, who make REAL mistakes.
    Any true calculation of costs should take into account the less obvious and intermittently incurred costs, the unpredictable, but expected (that is not a contradiction in terms) additional costs of mistakes and accidents -i.e. implicit costs. It happens in any industry or undertaking – not just in the oil industry. The costs of airline crashes would be an example. They are not planned, they are intermittent and infrequent but they are real nonetheless.

    In the current case of gummed up beaches, oily pelicans and fish – those are some of the less obvious costs of procuring the energy that drives a modern economy/society. One might argue that the costs are too great. OK, let’s accept that arguendo. So let’s assume that government regulators compell oil producers to add new equipment, take additional precautions, etc. “to ensure that such things don’t happen again” fine, but something else and unforeseen will happen, as it always will). As a result, in order to comply with the new regulations, the producers’ tangible and obvious (explicit) costs go up, not just for the offending driller (e.g. BP) but for all drillers. So, because of inefficiencies of one producer all producers have to incur additional costs – all of which will be passed through to the consumer. Fisherman and fish consumers foot the bill.

    If it was just BP its total costs would not change, they merely change their character – from the the implicit, unforeseen and deferred costs (oily beaches and pelicans and compensation to fisherman) to the explicit, increased costs of operation, capital, etc. BP’s prices, which up until now, have excluded the unforeseen costs, would have to account for those added costs. However, since BP is unable to affect the market price, it is going to be reflected in reduced profits. If they make too many of these mistakes they will be driven out of business and less accident prone suppliers will take their place. But if this does result in new regulation all producers will take the unforeseen costs (which have not been a factor in their prices) and transfer them to tangible costs of compliance, which they will not be able to avoid factoring into their prices.

    Result – price of energy for fishermen goes up, the consumers’ price for fish goes up, the quantity of fish demanded goes down. Has anything changed? And it is not just fishermen. The price of gas goes to $5.00 a gallon, vacationers stay closer to home and don’t drive to the pristine beaches unfouled by slime, and as a result beachfront hoteliers and eateries go broke. But …. the beaches are clean.

    What if the government says “Not good enough! The costs of high risk drilling (i.e. oily beaches and pelicans and whatnots) is too high. We must stop all offshore drilling and the marine transportation of oil (remember Exxon Valdez?).”
    OK, but the same issues arise. Quantity supplied goes down, demand stays the same so prices go up. Fisherman have to resort to fishing in sail boats, price of fish triples, consumers have to learn to like Spam.

    It seems to me the fisherman and others affected by the oil blow out are being a bit disingenuous (not that I blame them – I would be pissed too). They have been enjoying the benfits of cheap energy and now some of the implicit costs are being factored into the equation and they don’t like the true cost of gasoline. If they don’t like the cost of gasoline imagine what their costs (and revenues) would be if they had to resort to sails and packing their catch in ice shipped down from the arctic.

    It is not unlike someone taking a home mortgage with a low “teaser rate” going in and a big balloon payment after five years. At the end of the five years the true cost of buying the home and taking out the mortgage has to be dealt with.

  • 7 Scott // Jun 2, 2010 at 2:42 pm

    Note also that commercial fishermen in the South Atlantic area (Carolinas, GA, east coast of FL) are getting a positive benefit in terms of price boosts since they harvest most of the same species and their supply is not affected by the spill.

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