While reading through columns this morning I saw a perfect example of economic illiteracy in the comments:

Lower prices always benefits the consumer, no argument there.

And for the short term, we all love these lower gas prices. My son in high school, who works and pays his own gas bill, loves it right now.

But long term, I do predict $5/gallon in a few years (I also predicted the Colts would win the super bowl this year :-).

Do get me wrong, we have plenty of oil in the world for many years. But if the world does not reduce or even level off demand around 85 million bpd, we are screwed.

I read your supply&demand post from yesterday. Demand has drop by 200,000 bpd or 0.2%. Yet this caused a 65% from in gas prices.

Using this supply&demand curve from econ 101, will a 0.2% increase in demand cause a 65% increase in gas prices?

Now, there are so many errors in this, where to start? (At least people are finally admitting that supply and demand are responsible for oil prices, and not trying to pin it on "evil speculators" or "big oil" any longer.)

Well, first I will start by saying that the entire underlying assumption, that there is some "peak oil" value which we are close to reaching, is just wrong. I have demonstrated this before, and even the favorable essays I have read prove their own intellectual poverty, so there is no
need to go into that.

However, even ignoring that, and conceding the "peak oil argument", there is quite a bit wrong with the author's supposed understanding of "ECON 101".

First, if a 2% drop results in a 65% drop in price, it does not follow that a 2% increase will result in a 65% rise. Why not? Because it is a CURVE. Curves do not have a linear response, but instead respond differently at different points. Unless he means when we retrace the exact same points we will see the exact same response, there is no way to assume a similar move in the X direction will result in the same movement on Y, in fact, thanks to the formulae for most curves, it is almost impossible that two points exist where an identical move on X will result in the same move on Y.

However, let us assume he means we will move on X over the same ground and thus find our way back to the same Y. There is still a big problem in that he is assuming the "supply and demand curves" are static structures. The assumption being, once we have established a response to an increase or decrease in price, unless some huge, obvious change takes place, that the same price change will produce the same response. But that simply is not true. These "curves", which are largely intellectual fictions, as I described before, are the product of millions of tiny decisions which change constantly, mostly based on consumer preference. However, if consumers decide they prefer carbon fiber to steel in one product, it will lower the cost of steel slightly, which will reduce the cost of new rigs slightly, which will reduce the cost of oil. And there are billions of such changes in both supply and demand which can change either curve, making any assumptions of a static curve simply absurd.

Finally, there is the bizarre assumption that the current supply and demand represent nothing but current conditions, that there must be some grand, obvious action for an change to occur in the supply or demand. However, that completely ignores the fact that current market conditions are driven by assumptions about future markets, and nothing but a change in expectations can cause a dramatic change in the supply or demand without any significant change in the physical market conditions of the moment. For example, with the rise of oil above $5 a gallon, it became obvious that politicians would allow off shore drilling and, probably, exploitation of ANWR, and with those assumptions came a drop in price without a single barrel being produced or a single exploratory well being drilled. However, should prices rise again, the old assumptions will not return. In fact, if anything, the new price increase will speed the investment in such projects creating assumptions of even more oil, and thus dampening the increases in prices as demand rises.

Then again, these assumptions are not that odd among those who study formal economics, as economics has largely forgotten the difference between real conditions and simplify assumptions. Even in an abstract field such as game theory I can point to simply absurd assumptions, so it is not surprising those who studied ECON 101 don't realize that many assumptions are not true representations of reality, but simply ways to make the problems more easily understood. However, some of these assumptions are not part of the simplifying assumptions, but simply artifacts of lazy econ professors.

For example, that first error, thinking there is a linear slope to the supply and demand curves, that is not the fault of simplifying assumptions, or even of a misunderstanding on the part of the author. Instead, I think it is an artifact of lazy professors who can't be bothered to draw curves when explaining supply and demand. Since professors draw lines, it is easy for students to assume there is some sort of linear response to price changes.

But that sort of foolishness is relatively rare. Most economic illiteracy is not the result of lazy professors, but instead of lazy thinking by professors. Professors often, because they have lived with economic calculations for so long, tend to think that the economy is somehow a massive mechanistic system, that given enough data points it is predictable. And that simply is not true. We can predict the direction the economy will take in broad outlines, but the sort of minute calculations predicted by both professional economists and this poster are simply impossible. With prices being based on the composite value of individual valuations, there simply is no way to anticipate how the interaction of billions of relative valuations will combine to produce a single price. And economists need not only to understand that but to pass it along to their students.

Sadly, almost always when someone says "let me see if I recall ECON101", what follows is absolute gibberish. Since we can't blame all of that upon faulty memories, some of it must be laid at the feet of economics professors.

POSTSCRIPT

Unfortunately, most of the things I can blame on economics professors are not the fault of the professors, at least not their fault for failing to clearly explain things. They explained quite well, the problem is that they make absurd assumptions in their own work and then pass them along to their students. Sadly, the belief we can precisely model the economy, or scientifically manage it, are not restricted to students or political fringe parties. Many accepted economists share these absurd beliefs.