Tuesday, 30 December 2014

How Increased Inefficiency Explains Falling Oil Prices

Since about 2001, several sectors of the economy have become increasingly inefficient, in the sense that it takes more resources to produce a given output, such as 1000 barrels of oil. I believe that this growing inefficiency explains both slowing world economic growth and the sharp recent drop in prices of many commodities, including oil.

The mechanism at work is what I would call the crowding out effect. As more resources are required for the increasingly inefficient sectors of the economy, fewer resources are available to the rest of the economy. As a result, wages stagnate or decline. Central banks find it necessary lower interest rates, to keep the economy going.

Unfortunately, with stagnant or lower wages, consumers find that goods from the increasingly inefficiently sectors are increasingly unaffordable, especially if prices rise to cover the resource requirements of these inefficient sectors. For most periods in the past, commodities prices have stayed close to the cost of production (at least for the “marginal producer”). What we seem to be seeing recently is a drop in price to what consumers can afford for some of these increasingly unaffordable sectors. Unless this situation can be turned around quickly, the whole system risks collapse.

Increasingly Inefficient Sectors of the Economy 

We can think of several increasingly inefficient sectors of the economy:

Oil. The problem with oil is that much of the easy (and thus, cheap) to extract oil is gone. There seems to be a great deal of expensive-to-extract oil available. Some of it is deep under the sea, even under salt layers. Some of it is very heavy and needs to be “steamed” out. Some of it requires “fracking.” The extra extraction steps require the use of more human labor and more physical resources (oil and gas, metal pipes, fresh water), but output rises by very little. Liquid extenders to oil, such as biofuels and coal-to-liquid operations, also tend to be heavy resource users, further exacerbating the problem of the rising cost of production for liquid fuels.

I have described the problem behind rising costs as increasing inefficiency of production. The technical name for our problem is diminishing returns. This situation occurs when increased investment offers ever-smaller returns. Diminishing returns tends to occur to some extent whenever resources of any kind are extracted from the ground. If the extent of diminishing returns is small enough, total costs can be kept flat with technological advances. Our problem now is that diminishing returns have grown to such an extent that technological advances are no longer keeping pace. As a result, the cost of producing many types of goods and services is growing faster than wages.

Fresh Water. This is another increasingly inefficient sector of the economy, in terms of the amount of fresh water that can be produced with a given amount of resource investment. In some places deeper wells are needed; in others, desalination plants. Water from deeper wells may need additional treatment to remove the harmful minerals and radiation found in water from deeper wells.

As a result of the extra investment required, the price of fresh water is rising in many parts of the world. The higher cost is often justified as necessary to encourage conservation of a scarce resource. But from the point of view of the buyer, what is happening is an increasing price for the same product, or diminishing returns.

Grid Electricity. The price of grid electricity has been rising faster than inflation in many parts of the world for a variety of reasons. If nuclear plants are planned, they are being made in ways that are hopefully safer, but are more expensive. Adding solar PV and offshore wind is expensive, especially when grid changes to accommodate them are considered as well. Functioning plants of various kinds (coal, nuclear) are being replaced with other generation because of pollution problems (CO2) or feared pollution problems (radiation). The cost of producing electricity then rises because the cost of electricity from a fully depreciated plant of any kind is extremely low. Building any kind of new facility, no matter how theoretically efficient over, say, the next 40 years, requires physical resources and people’s time, in the current time period.

As these changes are made, the amount of grid electricity output does not rise very much compared to the resources and human labor required in the current period. The user experiences a higher cost for the same product. From the perspective of the user’s pocketbook, the result looks like diminishing returns.

Metals and Other Minerals. In the same manner as oil, we extract the easiest (and cheapest) to extract minerals first. These minerals include metals and other substances such as uranium, lithium, and rare earth minerals. Part of the problem is that ores of lower concentration must be used, leading to a need to move larger amounts of extraneous material that later must be disposed of. These ores may be found deeper in the ground or in more remote locations, adding to extraction costs. Furthermore, oil is generally used in the extraction of these minerals. As the cost of oil cost rises, this adds to the cost of mineral extraction, making minerals increasingly unaffordable.  

Advanced Education of Would-Be Workers. If 20% of the work force needs college educations, it makes sense to provide 20% of young people workers with college educations. If the percentage of workers requiring college educations rises to 30%, it makes sense to provide 30% of young people with college educations. Small percentages of more advanced degree recipients are needed as well.

Instead of following a common sense approach of educating only the number of workers who need a given amount of education with that amount of education, in the United States we have gotten onto a treadmill of encouraging increasing numbers of young people to pursue bachelors, masters, and Ph.D. degrees. To make matters worse, universities have established requirements that faculty do more research and less teaching, whether or not research in a particular field can be expected to benefit the economy to any significant extent. To accommodate this research-intensive approach, a layer of deans is added to work on obtaining funding for research. In addition, students are often provided more comfortable dorms with private rooms and private baths, adding costs to obtaining advanced education but not really enhancing future job prospects.

All of this produces an incredibly expensive higher education system, with costs way out of proportion to the increased wages a student can expect to earn from attending the university. Students are expected to pay for much of the cost of this system through debt to be paid back after graduation (or after dropping out). In some ways, the system might be viewed as an extremely expensive system of sorting out would-be job applicants, with widget makers with a college degree or master’s degree viewed more favorably than ones without, even if there is little use for an advanced degree in that particular job.

US Medical System. The US Medical system is particularly affected by the trend toward more advanced degrees. This approach results in a system where patients need to visit a variety of specialists to handle fairly common ailments, such as a broken arm or dementia in old age. To compensate for the high cost of their advanced education, specialists charge high fees. Hospitals have a large number of testing instruments at their disposal and use them whenever there is even slight justification.

Health outcomes in the US are remarkably bad compared to other developed countries, based on a study by the US Institute of Medicine called U.S. Health in International Perspective: Shorter Lives, Poorer Health.

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