Economists Do It With Models

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On Guns, Butter and Broken Windows, Now With More Oil…

June 20th, 2010 · 14 Comments
Econ 101 · Environmental Econ · Macroeconomics

I suppose I shouldn’t be surprised that the “but the oil spill is creating jobs” line is being trotted out in political circles, since this is often where economic and political realities come together to crash and burn in an intellectual blaze of glory. Here’s the reality: everyone in this debate is both wrong and not wrong.

Economists are right in that touting the supposed economic benefits of the oil spill is a direct application of the broken windows fallacy and that politicians are overlooking the fact that the resources being put to use to clean up the oil could have been put to use making something else if there was no oil to clean up. This latter option would lead to a similar employment outcome to oil cleanup, since we would have given people the same amount of money to make Beanie Babies or whatever rather than clean up oil, but it has the added benefit of having Beanie Babies at the end of the process, whereas oil cleaning just gets us back to the status quo. To summarize: Beanie Babies and no oil spill to clean is a strictly better outcome than a cleaned oil spill and no Beanie Babies. (Note that I am assuming Beanie Babies are not detrimental to society, which is potentially questionable.)

On the other hand, politicians are right if, without the oil spill, people would be sitting idle rather than making Beanie Babies. From a political perspective, it’s much easier to justify spending money to pay people to clean oil-coated pelicans and turtles than it it to justify randomly paying people to make Beanie Babies. If the Beanie Babies sans oil spill was not on the table for political reasons, then the “oil spill and oil cleanup” option looks pretty good, since it’s likely better than no oil spill, no cleanup and no Beanie Babies. (The reason for this is that the people who get paid to clean up the oil then spend at least some of what they make, which employs other people who then spend some of what they make, and so on, which results in a multiplier effect on the amount originally spent to employ the pelican cleaners.)

Given the above argument, it’s not surprising that some analysts are claiming that the oil spill could increase Gross Domestic Product, even when the losses in fishing and tourism output are taken into account:

The six-month moratorium on deep-water drilling may cut U.S. oil production by around 3% in 2011 and cost more than 3,000 jobs, according to J.P. Morgan’s energy analysts.

Commercial fishing in the Gulf is also likely to suffer, but that’s only about 0.005% of U.S. GDP. The impact on tourism is the hardest to measure, although it’s fair to expect that many hotel workers who lose their jobs will find it hard to get new ones.

Still, cleaning up the spill will likely be enough to slightly offset the negative impact of all this on GDP, J.P. Morgan said. The bank cites estimates of 4,000 unemployed people hired for the cleanup efforts, which some reports have said could be worth between $3 and $6 billion.

“If realized, this would likely mean a near- to medium-term boost to activity that might offset the drags,” Feroli said.

It’s probably not surprising to you that the article also points out that using a GDP snapshot to measure an economy’s long-term well-being can be somewhat problematic. The reason that GDP can sometimes give a skewed picture of economic health is because it looks at current aggregate production only and doesn’t account for what is actually produced or what the stock of resources in an economy is.

To analyze this issue, let’s think back to a model of the production possibilities frontier. The production possibilities frontier shows the different combinations of output that an economy can produce if it uses all of its resources. Typically, the production possibilities frontier is shown using representative capital and consumer goods, namely guns and butter. (You can see some videos on the topic here and here.) Right now, however, it makes sense to instead talk about goods in terms of oil cleanup (capital goods) versus iPhones (consumer goods), so let’s go with that:

The bowed-out line is the production possibilities frontier (PPF) itself, and it slopes down and to the right because societies face tradeoffs- if a society is using all of its resources and wants to produce more iPhones, it has to produce less oil cleanup and vice versa. I took the liberty of labeling a somewhat arbitrary point that represents what production would have been if there had been no oil spill, and you can see that it is inside rather than on the PPF curve. The reason for this is that there was above-normal unemployment before the spill, which means that the economy wasn’t using all of its resources.

After the oil spill, people were put to work cleaning beaches, pelicans and sea turtles. Some of these people had been unemployed before the spill, so there wasn’t much of a tradeoff to be had in putting them to work, at least in terms of human resources. Therefore, you will notice that the point labeled “today’s production” shows a big increase in the production of oil cleanup but only a small decrease in the production of iPhones. (This decrease represents the fact that not all of the cleanup workers had been previously unemployed. Technically speaking, the oil spill also shifted the PPF inward a tad, since the economy can’t produce as many fish as it could before, and fish is technically a subset of iPhones for the purposes of this model.) This is essentially a pictoral representation of how the oil spill can have a positive impact on today’s GDP, since it moves the economy from an inefficient to an efficient production point.

If we think in a longer-term sense, on the other hand, the picture looks much different. One of the big differences between capital and consumer goods is that the production of capital goods adds to the capital stock of the economy, which in part determines the possible production levels in the future. (This is just a fancy way of saying “an economy can make more stuff if it has more machines.”) Capital goods are usually pretty durable, but they do depreciate to some degree, so an economy must put some resources toward producing capital goods to maintain the status quo level of capital. In this sense, what the oil spill has done is sharply increase the level of investment required in capital (read, non-consumer) goods and services to maintain the status quo level of productivity.

The blue and pink lines on the above graph illustrate this last point- if there had been no oil spill, today’s level of resource investment in capital goods would have been more than enough to offset depreciation, and we would have ended up with more capital stock than we have today. The oil spill has most likely made it that, even with the increase in resources directed towards capital goods, the U.S. is going to see its capital stock decrease.

The above graph shows the effect of the oil spill on the choices available tomorrow. Whereas today’s level of investment would have led to an increase in productive capital and more production possibilities (the pink line), we will instead probably see a decrease in productive capital and fewer production possibilities in the future than we have today (the blue line).

Feel free to print this and include it in your hate mail to BP.

Tags: Econ 101 · Environmental Econ · Macroeconomics

14 responses so far ↓

  • 1 ramblingperfectionist // Jun 21, 2010 at 6:37 am

    Awesome 🙂 . I think I knew about all the concepts you mention here, but I hadn’t actually connected them until I read this post.

  • 2 Patrick Cowie // Jun 21, 2010 at 6:52 am

    Hating BP may be a good idea emotionally but not economically – a boycott of their products means that profits and cash flow will be damaged and thus they will have less money with which to clean-up the oil and to compensate local businesses and consumers. It will further ‘hit’ shareholders of whom 39% are Americans – thus American pensioners will, in part, be paying the clean-up costs. The really big story, of course, is ‘peak oil’ – if we are to keep our cars and planes moving and our economy growing, oil companies will have to develop very high risk fields – the ‘low-hanging fruit’ has long since been plucked and eaten. If the oil companies had to pay the full cost of their various spills (‘internalising the externality’) – see the Niger Delta, etc then the price per barrel would be – who knows? $150? $200?

  • 3 Patrick Cowie // Jun 21, 2010 at 6:53 am

    Excellent website, by the way!

  • 4 On guns, butter and broken windows, now with more oil… - Viewsflow // Jun 21, 2010 at 8:05 am

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  • 5 Dr. Goose // Jun 22, 2010 at 10:09 pm

    “All’s not lost in the Gulf,” said the pol;
    “The cleanup makes jobs – that’s the goal.”
    “But imagine instead,”
    The economist said,
    “If those jobs played a more gainful role.”

    “In recession, we wait for green shoots
    To bring jobs to the idle grass roots;
    So the cleanup campaign,”
    Said the pol, “Won’t detain
    Our workers from gainful pursuits.”

    The economist frowned with sagacity:
    “The work from the cleanup will pass,” said she;
    “Beyond current enjoyment,
    This surge in employment
    Isn’t building tomorrow’s capacity.”

    – Inspired by economist Jodi Beggs’ interpretation of the classic “Broken Window Fallacy.”

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    Excellent explanation! Thorough and clear! Good work!

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