Oil Prices

A former student writes in:

Oil prices were high in the 1970s, and we had a recession. Oil prices are now a third of what they were this summer... and the economy seems to be suffering. I remember learning in my undergrad that energy prices play a significant part in the economy overall. But, I thought the cheaper the energy...the better off the economy. So, what's going on now? Would we somewhat better off if gas prices increased?

Changes in oil prices can either cause, or be caused by, broader changes in the economy. That is, the causality can go both ways.

In the 1970s, oil prices rose in the US because of the Arab Oil Embargo. This caused a recession in the United States. The reason for this is that oil was an input into many firms' production processes. When input prices rise, firms produce less. This makes GDP (gross domestic product --- the sum value of all goods and services produced) go down. It also makes employment go down. Think of a trucking firm that hauls fewer loads because diesel is more expensive; this means fewer truck drivers will be employed.

In today's US economy, oil prices are much less important. We have fewer manufacturing jobs and more service jobs. Manufacturing jobs tend to be ones where "energy" is combined with "labor" to make "output". These are the jobs that go away when oil prices rise. In service industries (like mine), the price of oil has only a very minor impact on costs. So these jobs don't go away when oil prices go up.

This is why the changes in oil prices we saw from Jan 2007 to Aug 2008 didn't cause a severe recession.

Our current troubles are driven largely by the problems in the financial sector. We were already in a recession by Sept 2008, but the collapse of Lehman Brothers and subsequent problems in the credit markets have led to a serious economic slowdown.

Consumers in the US are spending a lot less money as a result. And this means less demand for "stuff." Because there's less demand for stuff, firms that manufacture things are cutting back. They're cutting back on output, which means using less labor and less energy. Unemployment in China has risen, due to reduced demand for workers by Chinese firms. Because these firms don't want as much energy, the demand for oil has fallen, and this is what has caused the recent drop in the price of oil. Think about all the TVs that aren't getting bought because US consumers feel poor. Those TVs would have been shipped from China on boats, and boats run on oil. This is a drop in the demand for oil, and this is why prices have fallen.

So, in the 1970s high oil prices caused the economy to struggle. Now, a struggling economy has caused oil prices to fall.

Here's a link to a recent NPR story that hits on the interconnectedness of the global economy that draws out some of these themes.

Winter Break Reading

I'll get back to the personnel economics of U budget cuts tomorrow maybe, but some winter reading for today.

Two of the books I read over the winter break were related, and they were:
Wallace Stegner's Beyond the Hundredth Meridian: John Wesley Powell and the Second Opening of the West
Mark Stein's How the States Got Their Shapes

I certainly wasn't expecting to see a connection, but one of Powell's proposals (in the late 1800s) involved the economics of political boundaries, which is the topic of the second book.

Powell recognized, long before most anyone else, that water was the crucial resource in the American West. This is unlike the Eastern US, where there's plenty of water falling from the sky ("rain", I guess they call it) onto any piece of land. Here, we don't get too much of this "rain" stuff. For most agricultural purposes, land is useless without water. Powell argued that the homestead laws used to settle places like Iowa just weren't going to work in the West. It just wasn't going to work to give individuals 160 acres --- the standard grant under the Homestead Act --- with no thought about where water was going to come from.

One of Powell's water-centric proposals was made to the Montana territorial legislature. He advised them to organize counties according to drainage basins. If all residents on a particular creek or river are members of the same county, then water usage decisions can be delegated to that county and resolved locally. Essentially, Powell was arguing that political boundaries ought to be drawn to allow for localized decision-making regarding scarce resources. He was ignored, of course, and this means that upstream counties and downstream counties fight over water rights. One problem with this political organization is that both upstream and downstream counties act in a completely self-interested manner, and issues are either resolved by the state (which has comparatively limited access to information on local conditions) or through protracted negotiations. Witness the problems of the Colorado River Compact --- which is an agreement of seven Colorado-River-basin states --- for examples of the exact problems Powell was hoping Montana could avoid.

This year is the 100th anniversary of Stegner's birth, so it's a good year to read him. I'm not a big fan of fiction --- why read something made up when the real world is so interesting? --- but he wrote lots of great non-fiction stuff about the West (and about Mormonism in particular).

Mark Stein's book is about how Powell's advice --- design political units to minimize across-jurisdiction conflict --- was sometimes heeded and sometimes ignored as the Congress drew up state boundaries. Under "heeded", have a look at Washington and Idaho. Gold was discovered in what-was-then the Washington Territory north of Boise in 1860. Miners flocked to the area. Farmers in the Puget Sound area did not want miners in Boise making laws for them (and vice versa), so Congress split the territory in two.

Under "ignored", look at Wyoming. It's four degrees of latitude high, and seven degrees of longitude wide. Same with Colorado. Congress was pretty much ignoring conditions on the ground, and just making similar-sized states out of blank spaces on the map.

From Stein's book, I also learned that Utah is smaller than originally planned. Much of eastern Nevada was part of Utah --- until the mining really got going there. Congress didn't trust the LDS settlers of Utah, so they lopped off big chunks of land and put them in Nevada (which Congress figured wouldn't be LDS-controlled) instead.

West Wendover was nearly ours!

U Budget Cuts

As you probably know, the U's budget has been cut, and probably will be cut again. I'm on the U's "Salaries and Annuities" committee, and I attended a meeting yesterday with the committee and some high-up administrators.

Faculty salary cuts are being considered, depending on the size of the cut coming from the legislative session.

But what a great meeting!

The reason this was a great meeting is that I study labor markets, employment relationships, and how to structure decisions in organizations. And this meeting had all these issues.

(As an aside: Pretty much everything that has happened since September 17 has been bad for my portfolio and salary --- just like everyone else's. But for me it's been interesting professionally. In expressing my interest, I risk coming off like I'm enjoying this. I'm not --- and on top of that I know that a lot of people are hurting from job loss. I'd for sure undo it if I could.)

The U is facing a bunch of interesting decisions right now, and I'll probably blog about them over the next week or so. One decision is this: If the U needs to cut faculty salaries by X%, how should it do so? Here are a couple of options:
(1) Reduce every professor's salary by X%.
(2) Tell each college that its total salary amount has to fall by X%, but let the deans and department chairs determine how to achieve that goal.

Fundamentally, this question is one about delegation of decisions. It's about where we should put decision-making responsibility in this organization. Option (1) is central administration making the decision. Option (2) is central administration delegating the decision to the deans and department chairs, subject to some parameters. It's exactly the kind of issue we consider in Fin 6250.

So what are the economics of delegation?

As with everything in life, delegation involves tradeoffs. There are benefits and costs associated with delegation, and it's important to weigh them carefully.

On the benefit side, delegation often means you're better able to make use of local information. What does that mean in this context? As one example, deans and department chairs know best about the labor market conditions in their particular fields. Central administration doesn't know (at least, not as well as the deans and department chairs) which of the finance professors are highly sought after by other universities, and which are not. In cutting salaries, you're providing opportunities for rival employers to pick off your best faculty. Choosing option (2) allows deans and department chairs to be a bit strategic about any salary cuts. It allows them to make smaller cuts in cases where labor market competition is intense, and larger cuts where the competition isn't so intense. This is potentially beneficial, in that it might allow the U to do a better job of retaining faculty.

There are a couple of potential costs of delegation. The first is agency costs. Deans and department chairs might have different preferences from central administration. It's possible --- at least in principle --- that deans might not allocate scarce salary dollars in the way that central administration thinks is best for the university as a whole. The best example of this comes from thinking about across-department and across-school externalities. Suppose there's a math professor who spends a lot of time working with faculty and students from the school of engineering. The math department might not value this person so much, and might decide to focus salary resources elsewhere. If this person left, it might hurt the school of engineering, but the math department might not take that into account.

A second potential cost comes from coordination problems, but I'm hard pressed to come up with an example of this one in the context of university salary cuts. In Chapter 3 of the forthcoming fifth edition of my book Economics of Strategy, I write about coordination in military organizations. Delegating decisions to lower-level commanders in military operations is often not a good idea, because actions of different units need to be coordinated. Attacks might work best if all units attack at the same moment, and as a result delegating decisions might achieve the best outcome. One good example of coordination in for-profit firms comes from marketing campaigns --- it's sometimes best if a firm's various products are marketed using a consistent message. Delegating decisions to product-level marketing groups might fail to deliver that consistent message, and so it can be good to have centralized oversight of such choices.