In yesterday's post, I noted that when there is a decrease in supply (in that case, in the market for broccoli), prices increase but sellers' profits (producer surplus) actually decreases. That should make you wonder about some other markets that have been in the news recently, where supply has decreased, such as the market for oil. However, in that case, as 1News reported last month:
London-based BP said underlying replacement cost profit, which excludes one-time items and fluctuations in the value of inventories, jumped to $27.7 billion ($43.8 billion NZD) in 2022 from $12.8 billion ($20.3 billion NZD) a year earlier.
That beat the $26.8 billion ($42.4 billion NZD) BP earned in 2008, when tensions in Iran and Nigeria pushed world oil prices to a record of more than $147 ($233 NZD) a barrel.
The oil market has also faced a negative supply shock, which has increased the market price of oil. Shouldn't profits be decreasing for oil producers like BP? Not quite. In the case of oil, the decrease in supply is very concentrated on Russian oil. Russian oil producers are facing decreased supply, because it is more difficult (and more expensive) for them to sell oil. This is shown in the diagram below (which is the same diagram as yesterday). The supply of Russian oil decreased from S0 to S1. The equilibrium price increases from P0 to P1, and the quantity of Russian oil traded decreases from Q0 to Q1. The producer surplus for Russian producers of oil decreases from the area P0BC to the area P1DE.
What about other (non-Russian) oil producers, like BP? With Russian oil becoming less available and more expensive to obtain, the demand for oil from non-Russian producers increases. This is shown in the diagram below. The demand for non-Russian oil increased from DA to DB. The equilibrium price increased from P0 to P1, and the quantity of non-Russian oil traded increased from QA to QB. The producer surplus for non-Russian producers of oil increased from the area P0FG to the area P1HG.
And so we end up in a situation of high profits for non-Russian oil producers like BP, leading to this (from the same 1News article):
But the good news for BP shareholders is likely to be tempered by the public fallout, particularly in its home country. High oil and gas prices have hit Britain hard, with double-digit inflation fuelling a wave of public sector strikes, soaring food bank use and demands that politicians expand a windfall tax on energy companies to help pay for public services.
Ed Miliband, the opposition Labour Party’s spokesman on climate issues, called on the UK government to bring forward a “proper” windfall profits tax on energy companies.
“It’s yet another day of enormous profits at an energy giant, the windfalls of war, coming out of the pockets of the British people,″ Miliband said.
My first thought about a windfall profits tax is that it's a bit of overkill. Business profits are taxed already. Higher business profits mean that the business will pay more tax already. Most argument I have read in favour of the windfall profits tax use an argument related to fairness. BP's high profits haven't arisen as a result of BP's outstanding management, their forward planning and investment strategies, improved quality of their product, or improved processing technology. In all of those cases, it might be seen as fair for a producer to reap higher profits. BP's higher profits are a pure windfall that they had no hand in generating. I don't find this fairness argument convincing, but I can see why it is attractive for many people.
However, I do think that there is a symmetry argument that could be used to justify windfall profits. When times are tough, businesses often call on the government for help. We saw this during the pandemic, when the New Zealand government paid wage subsidies to many employers. We've seen it more recently with tourism and hospitality operators asking for further assistance from the government. So, when businesses are not doing so well, they sometimes (maybe often, depending on how strongly they are able to lobby government) receive additional assistance. For the sake of symmetry then, when businesses are doing well, they should be voluntarily paying the government more in tax. If they aren't willing to do so voluntarily, then that may justify a windfall tax. Businesses shouldn't simply expect an asymmetric relationship with the taxpayer, where they are bailed out when they are doing badly, but keep their excess profits when they are doing well.
On the other hand, there may be good reason to bail out businesses, even if there is no such symmetry in the taxpayer-business relationship (more on that in my next post).
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