For want of a piston ring costing $1.50, nearly 70% of Japan’s auto production has been temporarily paralyzed this week.{453} #101 | | |
Having either too large or too small an inventory means losing money. Clearly, those businesses which come closest to the optimal size of inventory will have their profit prospects enhanced. More important, the total resources of the economy will be allocated more efficiently, not only because each enterprise has an incentive to be efficient, but also because those firms which turn out to be right more often are more likely to survive and continue making such decisions, while those who repeatedly carry far too large an inventory, or far too small, are likely to disappear from the market through bankruptcy. #102 | | |
Too large an inventory means excess costs of doing business, compared to the costs of their competitors, who are therefore in a position to sell at lower prices and take away customers. Too small an inventory means running out of what the customers want, not only missing out on immediate sales but also risking having those customers look elsewhere for more dependable suppliers in the future. As noted in Chapter 6, in an economy where deliveries of goods and parts were always uncertain, such as that of the Soviet Union, huge inventories were the norm. #103 | | |
Some of the same economic principles involving risk apply to activities far removed from the marketplace. A soldier going into battle does not take just the number of bullets he will fire or just the amount of first aid supplies he will need if wounded in a particular way, because neither he nor anyone else has the kind of foresight required to do that. The soldier carries an inventory of both ammunition and medical supplies to cover various contingencies. At the same time, he cannot go into battle loaded down with huge amounts of everything that he might possibly need in every conceivable circumstance. That would slow him down and reduce his maneuverability, making him an easier target for the enemy. In other words, beyond some point, attempts to increase his safety can make his situation more dangerous. #104 | | |
Inventory is related to knowledge and risk in another way. In normal times, each business tends to keep a certain ratio of inventory to its sales. However, when times are more uncertain, such as during a recession or depression, sales may be made from existing inventories without producing replacements. During the third quarter of 2003, for example, as the United States was recovering from a recession, its sales, exports, and profits were all rising, but BusinessWeek magazine reported that manufacturers, wholesalers, and retailers were “selling goods off their shelves” and “the ratio of inventories to sales hit a record low.”{454} #105 | | |
The net result was that far fewer jobs were created than in similar periods of increased business activity in the past, leading to the phrase “a jobless recovery” to describe what was happening, as businesses were not confident that this recovery would last. In short, for sellers the selling of inventory was a way of coping with economic risks. Only after inventories had hit bottom did the hiring of more people to produce more goods increase on such a large scale as to make the phrase “a jobless recovery” no longer applicable. #106 | | |
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Although many goods and services are bought for immediate use, many other benefits come in a stream over time, whether as a season’s ticket to baseball games or an annuity that will make monthly pension payments to you after you retire. That whole stream of benefits may be purchased at a given moment for what economists call its “present value”—that is, the price of a season’s ticket or the price paid for an annuity. However, more is involved than simply determining the price to be paid, important as that is. The implications of present value affect economic decisions and their consequences, even in areas that are not normally thought of as economic, such as determining the amount of natural resources available for future generations. #108 | | |
Prices and Present Values #109 | | |
Whether a home, business, or farm is maintained, repaired or improved today determines how long it will last and how well it will operate in the future. However, the owner who has paid for repairs and maintenance does not have to wait to see the future effects on the property’s value. These future benefits are immediately reflected in the property’s present value. The “present value” of an asset is in fact nothing more than its anticipated future benefits, added up and discounted for the fact that they are delayed. Your home, business, or farm may be functioning no better than your neighbor’s today, but if the prospective toll of wear and tear on your property over time is reduced by installing heavier pipes, stronger woods, or other more durable building materials, then your property’s market value will immediately be worth more than that of your neighbor, even if there is no visible difference in the way they are functioning today. #110 | | |
Conversely, if the city announces that it is going to begin building a sewage treatment plant next year, on a piece of land next to your home, the value of your home will decline immediately, before the adjoining land has been touched. The present value of an asset reflects its future benefits or detriments, so that anything which is expected to enhance or reduce those benefits or detriments will immediately affect the price at which the asset can be sold today. #111 | | |
Present value links the future to the present in many ways. It makes sense for a ninety-year-old man to begin planting fruit trees that will take 20 years before they reach their maturity because his land will immediately be worth more as a result of those trees. He can sell the land a month later and go live in the Bahamas if he wishes, because he will be receiving additional value from the fruit that is expected to grow on those trees, years after he is no longer alive. Part of the value of his wealth today consists of the value of food that has not yet been grown—and which will be eaten by children who have not yet been born. #112 | | |
One of the big differences between economics and politics is that politicians are not forced to pay attention to future consequences that lie beyond the next election. An elected official whose policies keep the public happy up through election day stands a good chance of being voted another term in office, even if those policies will have ruinous consequences in later years. There is no “present value” to make political decision-makers today take future consequences into account, when those consequences will come after election day. #113 | | |
Although the general public may not have sufficient knowledge or training to realize the long-run implications of today’s policies, financial specialists who deal in government bonds do. Thus the Standard & Poor’s bond-rating service downgraded California’s state bonds in the midst of that state’s electricity crisis in 2001,{455} even though there had been no defaults on those bonds, nor any lesser payments made to those who had bought California bonds, and there were billions of dollars of surplus in the state’s treasury. #114 | | |
What Standard & Poor’s understood was that the heavy financial responsibilities taken on by the California government to meet the electricity crisis meant that heavy taxes or heavy debt were waiting over the horizon. That increased the risk of future defaults or delay in payments to bondholders—thereby reducing the present value of those bonds. #115 | | |
Any series of future payments can be reduced to a present value that can be paid immediately in a lump sum. Winners of lotteries who are paid in installments over a period of years can sell those payments to a financial institution that will give them a fixed sum immediately. So can accident victims who have been awarded installment payments from insurance companies. Because the present value of a series of payments due over a period of decades may be considerably less than the sum total of all those payments, due to discounting for delays, the lump sums paid may be less than half of those totals, {456}causing some people who sold, in order to relieve immediate financial problems, to later resent the deal they made. Others, however, are pleased and return to make similar deals in the future. #116 | | |
Conversely, some individuals may wish to convert a fixed sum of money into a stream of future payments. Elderly people who are retiring with what seems like an adequate amount to live on must be concerned with whether they will live longer than expected—“outlive their money” as the expression goes—and end up in poverty. In order to avoid this, they may use a portion of their money to purchase an annuity from an insurance company. For example, in the early twenty-first century, a seventy year old man could purchase an annuity for a price of $100,000 and thereafter receive $772 a month for life—whether that life was three more years or thirty more years. In other words, the risk would be transferred to the insurance company, for a price. #117 | | |
As in other cases, the risk is not only shifted but reduced, since the insurance company can more accurately predict the average lifespan of millions of people to whom it has sold annuities than any given individual can predict his own lifespan. Incidentally, a woman aged 70 would get somewhat smaller monthly payments—$725—for the same price, given that women usually live longer than men.{457} #118 | | |
The key point is that the reduced risk comes from the greater predictability of large numbers. A news story some years ago told of a speculator who made a deal with an elderly woman who needed money. In exchange for her making him the heir to her house, he agreed to pay her a fixed sum every month as long as she lived. However, this one-to-one deal did not work out as planned because she lived far longer than anyone expected and the speculator died before she did. An insurance company not only has the advantage of large numbers, it has the further advantage that its existence is not limited to the human lifespan. #119 | | |
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Present value profoundly affects the discovery and use of natural resources. There may be enough oil underground to last for centuries or millennia, but its present value determines how much oil will repay what it costs anyone to discover it at any given time—and that may be no more than enough oil to last for a dozen or so years. A failure to understand this basic economic reality has, for generations, led to numerous and widely publicized false predictions that we were “running out” of petroleum, coal, or some other natural resource. #121 | | |
In 1960, for example, a best-selling book said that the United States had only a 13-year supply of domestic petroleum at the existing rate of usage.{458} At that time, the known petroleum reserves of the United States were not quite 32 billion barrels. At the end of the 13 years, the known petroleum reserves of the United States were more than 36 billion barrels.{459} Yet the original statistics and the arithmetic based on them were both accurate. Why then did the United States not run out of oil by 1973? Was it just dumb luck that more oil was discovered—or were there more fundamental economic reasons? #122 | | |
Just as shortages and surpluses are not simply a matter of how much physical stuff there is, either absolutely or relative to the population, so known reserves of natural resources are not simply a matter of how much physical stuff there is in the ground. For natural resources as well, prices are crucial. So are present values. #123 | | |
How much of any given natural resource is known to exist depends on how much it costs to know. Oil exploration, for example, is very costly. In 2011, the New York Times reported: #124 | | |
Two miles below the ocean floor, on a ridge the size of metropolitan Houston, modern-day wildcatters have pinpointed what they believe is a major oil field. Now all they have to do is spend $100 million to find out if they’re right.{460} #125 | | |
The cost of producing oil includes not only the costs of geological exploration but also the costs of drilling expensive dry holes before striking oil. As these costs mount up while more and more oil is being discovered around the world, the growing abundance of known supplies of oil reduces its price through supply and demand. Eventually the point is reached where the cost per barrel of finding more oil in a given place and processing it exceeds the present value per barrel of the oil that you are likely to find there. At that point, it no longer pays to keep exploring. Depending on a number of circumstances, the total amount of oil discovered at that point may well be no more than the 13 years’ supply which led to dire predictions that we were running out. But, as the existing supplies of oil are being used up, rising prices lead to more huge investments in oil exploration. #126 | | |
As one example of the kinds of costs that can be involved, a major oil exploration venture in the Gulf of Mexico spent $80 million on the initial exploration and leases, and another $120 million for exploratory drilling, just to see if it looked like there was enough oil to justify continuing further. Then there were $530 million spent for building drilling platforms, pipelines, and other infrastructure, and—finally—$370 million for drilling for oil where there were proven reserves. This adds up to a total of $1.1 billion. #127 | | |
Imagine if the interest rate had been twice as high on this much money borrowed from banks or investors, making the total cost of exploration even higher. Or imagine that the oil companies had this much money of their own and could put it in a bank to earn twice the usual interest in safety. Would they have sunk as much money as they did into the more risky investment of looking for oil? Would you? Probably not. A higher interest rate would probably have meant less oil exploration and therefore smaller amounts of known reserves of petroleum. But that would not mean that we were any closer to running out of oil than if the interest rate were lower and the known reserves were correspondingly higher. #128 | | |
As more and more of the known reserves of oil get used up, the present value of each barrel of the remaining oil begins to rise and, once more, exploration for additional oil becomes profitable. But, as of any given time, it never pays to discover all the oil that exists in the ground or under the sea. In fact, it does not pay to discover more than a minute fraction of that oil. What does pay is for people to write hysterical predictions that we are running out of natural resources. It pays not only in book sales and television ratings, but also in political power and in personal notoriety. #129 | | |
In the early twenty-first century, a book titled Twilight in the Desert concluded that “Sooner or later, the worldwide use of oil must peak” and that is because “oil, like the other two fossil fuels, coal and natural gas, is nonrenewable.” That is certainly true in the abstract, just as it is true in the abstract that sooner or later the sun must grow cold. But that is very different from saying that this has any relevance to any problem confronting us in the next century or the next millennium. The insinuation, however, was that we faced some enduring energy crisis in our own time, and the fact that the price of crude oil had shot up to $147 a barrel, with the price of gasoline shooting up to $4 a gallon, lent credence to that insinuation. But, in 2010, the New York Times reported: #130 | | |
Just as it seemed that the world was running on fumes, giant oil fields were discovered off the coasts of Brazil and Africa, and Canadian oil sands projects expanded so fast, they now provide North America with more oil than Saudi Arabia. In addition, the United States has increased domestic oil production for the first time in a generation.{461} #131 | | |
Even the huge usages of energy resources during the entire twentieth century did not reduce the known reserves of the natural resources used to generate that energy. Given the enormous drain on energy resources created historically by such things as the spread of railroad networks, factory machinery, and the electrification of cities, it has been estimated that more energy was consumed in the first two decades of the twentieth century than in all the previously recorded history of the human race.{462} #132 | | |
Moreover, energy usage continued to escalate throughout the century—and yet known petroleum reserves rose. At the end of the twentieth century, the known reserves of petroleum were more than ten times as large as they were in the middle of the twentieth century.{463} Improvements in technology made oil discovery and its extraction more efficient. In the 1970s, only about one-sixth of all wells drilled in search of oil turned out to actually produce oil. But, by the early twenty-first century, two-thirds of these exploratory wells produced oil.{464} #133 | | |
The economic considerations which apply to petroleum apply to other natural resources as well. No matter how much iron ore there is in the ground, it will never pay to discover more of it when its present value per ton is less than the cost per ton of exploration and processing. Yet, despite the fact that the twentieth century saw vast expansions in the use of iron and steel, the proven reserves of iron ore increased several fold. So did the known reserves of copper, aluminum, and lead, among other natural resources.{465} As of 1945, the known reserves of copper were 100 million metric tons. After a quarter of a century of unprecedented increases in the use of copper, the known reserves of copper were three times what they were at the outset and, by 1999, copper reserves had doubled again.{466} The known reserves of natural gas in the United States rose by about one-third (from 1,532 trillion cubic feet to 2,074 trillion cubic feet), just from 2006 to 2008.{467} #134 | | |
Even after a pool of petroleum has been discovered underground or under the sea and the oil is being extracted and processed, economic considerations prevent that pool of oil from being drained dry. As The Economist magazine put it: #135 | | |
A few decades ago, the average oil recovery rate from reservoirs was 20%; thanks to remarkable advances in technology, this has risen to about 35% today.{468} #136 | | |
In other words, nearly two-thirds of the oil in an underground pool is left in the pool, because it would be too costly to drain out all of it—or even most of it—with today’s technology and today’s oil prices. But the oil is still there and its location is already known. If and when we are genuinely “running out” of oil that is available at today’s costs of extraction and processing, then the next step would be to begin extracting and processing oil that costs a little more and, later, oil that costs a little more than that. But we are clearly not at that point when most of the oil that has been discovered is still left underground or under the sea. As technology improves, a higher rate of production of oil from existing wells becomes economically feasible. In 2007 the New York Times reported a number of examples, such as this: #137 | | |
The Kern River oil field, discovered in 1899, was revived when Chevron engineers here started injecting high-pressured steam to pump out more oil. The field, whose production had slumped to 10,000 barrels a day in the 1960s, now has a daily output of 85,000 barrels. {469} #138 | | |
Such considerations are not unique to petroleum. When coal was readily available above ground, it did not pay to dig into the ground and build coal mines, since the coal extracted at higher costs underground could not compete in price with coal that could be gathered at lower cost on the surface. Only after the coal available at the lowest cost was exhausted did it pay to begin digging into the ground for more. #139 | | |
The difference between the economic approach and the hysterical approach to natural resource usage was demonstrated by a bet between economist Julian Simon and environmentalist Paul Ehrlich. Professor Simon offered to bet anyone that any set of five natural resources they chose would not have risen in real cost over any time period they chose. A group led by Professor Ehrlich took the bet and chose five natural resources. They also chose ten years as the time period for measuring how the real costs of these natural resources had changed. At the end of that decade, not only had the real cost of that set of five resources declined, so had the cost of every single resource which they had expected to rise in cost! {470}Obviously, if we had been anywhere close to running out of those resources, their costs would have risen because the present value of these potentially more scarce resources would have risen. #140 | | |
In some ultimate sense, the total quantity of resources must of course be declining. However, a resource that would run out centuries after it becomes obsolete, or a thousand years after the sun grows cold, is not a serious practical problem. If it is going to run out within some time period that is a matter of practical relevance, then the rising present value of the resource whose exhaustion looms ahead will automatically force conservation, without either public hysteria or political exhortation. #141 | | |
Just as prices cause us to share scarce resources and their products with each other at a given time, present value causes us to share those resources over time with future generations—without even being aware that we are sharing. It is of course also possible to share politically, by having the government assume control of natural resources, as it can assume control of other assets, or in fact of the whole economy. #142 | | |
The efficiency of political control versus impersonal control by prices in the marketplace depends in part on which method conveys the underlying realities more accurately. As already noted in earlier chapters, price controls and direct allocation of resources by political institutions require far more explicit knowledge by a relatively small number of planners than is required for a market economy to be coordinated by prices to which millions of people respond according to their own first-hand knowledge of their own individual circumstances and preferences—and the relative handful of prices that each individual has to deal with. #143 | | |
Planners can easily make false projections, either from ignorance or from various political motives, such as seeking more power, re-election, or other goals. For example, during the 1970s, government scientists were asked to estimate the size of the American reserves of natural gas and how long it would last at the current rate of usage. Their estimate was that the United States had enough natural gas to last for more than a thousand years!{471} While some might consider this good news, politically it was bad news at a time when the President of the United States was trying to arouse public support for more government programs to deal with the energy “crisis.” This estimate was repudiated by the Carter administration and a new study begun, which reached more politically acceptable results. #144 | | |
Sometimes the known reserves of a natural resource seem especially small because the amount available at currently feasible costs is in fact nearing exhaustion within a few years. There may be vast amounts available at a slightly higher cost of extraction and processing, but these additional amounts will of course not be touched until the amount available at a lower cost is exhausted. For example, back when there were large coal deposits available on top of the ground, someone could sound an alarm that we were “running out” of coal that is “economically feasible” to use, coal that can be gotten without “prohibitive costs.” But again, the whole purpose of prices is to be prohibitive. In this case, that prohibition prevented more costly resources from being resorted to needlessly, so long as there were less costly sources of the same resource available. #145 | | |
A similar situation exists today, when most of the petroleum found in an oil pool is left there because the costs of extracting more than the most easily accessible oil cannot be repaid by the current market price. During the oil crisis of 2005, when the price of gasoline in the United States shot up to double what it had been less than two years earlier, and people worried that the world was running out of petroleum, the Wall Street Journal reported: #146 | | |
The Athabasca region in Alberta, Canada, for instance, theoretically could produce about 1.7 trillion to 2.5 trillion barrels of oil from its 54,000 square miles of oil-sands deposits—making it second to Saudi Arabia in oil reserves. The Athabasca reserves remain largely untapped because getting the oil out of the sand is expensive and complicated. It takes about two tons of sand to extract one barrel of oil. But if oil prices remain near current levels—indeed, if prices stay above $30 a barrel, as they have since late 2003—oil-sands production would be profitable. Limited investment and production has been under way in Athabasca.{472} #147 | | |
If technology never improved, then all resources would become more costly over time, as the most easily obtained and most easily processed deposits were used up first and the less accessible, or less rich, or more difficult to process deposits were then resorted to. However, with improving technology, it can actually cost less to acquire future resources when their time comes, as happened with the resources that Julian Simon and Paul Ehrlich bet on. For example, the average cost of finding a barrel of oil fell from $15 in 1977 to $5 by 1998.{473} It is hardly surprising that there were larger known oil reserves after the cost of knowing fell. #148 | | |
Petroleum is by no means unique in having its supply affected by prices. The same is true for the production of nickel as well, for example. When the price of nickel rose in the early twenty-first century, the Wall Street Journal reported: #149 | | |
A few years ago, it would have been hard to find a better example of a failed mining project than Murrin Murrin, a huge, star-crossed nickel operation deep in the Western Australian desert. #150 | | |
