April 22, 2018

Economics: still the cheerful science!

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Five years ago I posted a blog on this site about a famous bet between the ecologist Paul Ehrlich and the economist Julian Simon.

Ehrlich had been the author of a best-selling and gloomy book warning that we were going to run out of basic commodities in the future. And that in turn was taken to mean that the price of these commodities would skyrocket.

Simon, being an economist, was more cheerful. He invited Ehrlich to choose any commodities he wished and any date more than a year away. Simon bet that the commodities’ real price would fall over that period. Ehrlich agreed and chose five commodities and a period of 10 years (the 1980s) for the bet.

Ten years later, Simon had won his bet. The prices of all five commodities had fallen. Oil was not in the wager, but its real price fell substantially over the same period. Ehrlich paid up in 1990.

The reasons for the price falls varied from case to case, but generally it was down to the market mechanism at work. A high price of a commodity signalled incentives to economise on it, explore for new reserves, find substitutes and search for technological innovations (like fuel efficiency). That was what Simon knew and was betting on.

Well, five years ago, when I wrote that blog, the price of oil was shooting up towards $120 a barrel (it actually hit that level in January 2012). There was gloomy talk of ‘peak oil’ in terms of output, suggesting that running out of oil could push the price up even further.

In such circumstances, would you have bet on the gloomy side (like Ehrlich), expecting the price of oil to shoot up further? Or would you have bet on the cheerful side (like the economist Simon), expecting the price of oil to fall over the next few years?

If you had bet cheerfully, you would have won. For most of this year the price of oil has hovered around the $40 a barrel mark.

I can hear you protesting that I have chosen the terms on which I want to argue for cheerfulness, and that there are a lot of things to be gloomy about. Of course there are, but the price of commodities is not one of them.

Trust me, I am an economist.

(I still do not know why the EBS MBA students laugh when I tell them that…)